In this article we will discuss about Financial Reporting:- 1. Concept of Financial Reporting 2. Objectives of Financial Reporting 3. Developments on Financial Reporting Objectives
Concept of Financial Reporting:
Financial reporting may be defined as communication of published financial statements and related information from a business enterprise to third parties (external users) including shareholders, creditors, customers, governmental authorities and the public. It is the reporting of accounting information of an entity (individual, firm, company, government enterprise) to a user or group of users.
Company financial reporting is a total communication system involving the company as issuer (preparer); the investors and creditors as primary users, other external users; the accounting profession as measurers and auditors; and the company law regulatory or administrative authorities.
Objectives of Financial Reporting:
An evaluation of company financial reporting requires some agreement on its objectives. Financial reporting is not an end in itself but is a means to certain objectives.
The objectives of financial reporting and financial statements have been discussed for a long time. While there is no final statement on objectives, to which all parties (of financial reporting) have agreed, some consensus has been developing on the objectives of financial reporting.
At present, the following may be described as the primary objectives of financial reporting:
(а) Investment Decision-making.
(b) Management Accountability.
(a) Investment Decision-Making:
The basic objective of financial reporting is to provide information useful to investors, creditors and other users in making sound investment decisions. These decisions concern the efficient allocation of investment funds and the selection among investment opportunities.
The True-blood Committee stated that “…the basic objective of financial statements is to provide information useful for making economic decisions.” Recently, the FASB (USA) in its Concept No. 1 also concluded that financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit and similar decisions.
It is essential to have an understanding of the investment decision process applied by external users in order to provide useful information to them. The investors seek such investment which will provide the greatest total return with an acceptable range of risk. Investment return is comprised of future interest or dividends and capital appreciation (or loss).
The investors while making investment decisions aim to determine the amount and certainty of a company’s future earning power in order to estimate their future cash return in dividends and capital appreciation. Earning power is the ability of a business firm to produce continuous earnings from the operating assets of the business over a period of years, which may differ from accounting net income.
The financial statements and other business data are analysed in relation to the enterprise’s environment to project this future earning power. Investors compare returns on alternative investments relative to risk, which (risk) is the degree of uncertainty of future returns. The risk premium is a measure of uncertainty which is defined as the possible variation of the actual from the expected return.
The investment decision process may be pictured as a three-legged stool. One leg is the analysis of the company and its securities and of the industry in which it operates. The second is the assessment of the economic environment, including the business outlook, financial markets and interest rates, international trade and finance, and political and regulatory developments.
The third is the portfolio decision in which these two streams of information are integrated into an investment appraisal related to the objectives of the investor—individual or fund.
Portfolio decisions sort out expected rates of return relative to risk, as the investor (portfolio manager) seeks that combination of securities which will produce the highest total return available within the risk constraints adopted for the portfolio. In this continual winnowing process, investment funds tend to flow toward the most favourably situated companies and industries and away from the weaker and less promising areas.
Investment decision and investment values, both, are comparative, not absolute. In all investment decisions, comparison is made in order to determine the most attractive (greatest) returns in relation to risk first, comparison between one type of security us. another; second, comparison between one company vs. another within each category; third, comparison within a company over time.
Comparison requires uniform standards of measurement. Where different accounting measurements are used in similar situations, investors and financial analysts make their own accounting adjustments to achieve comparability, provided adequate information is available to do so.
But the attribute of comparability can be achieved at a lower cost (associated with financial reporting system), and with equal benefit for all investors, by eliminating the alternatives.
(b) Management Accountability:
A second basic objective of financial reporting is to provide information on management accountability to judge management’s effectiveness in utilizing the resources and running the enterprise.
Management of an enterprise is periodically accountable to the owners not only for the custody and sale-keeping of enterprise resources, but also for their efficient and profitable use and for protecting them to the extent possible from unfavorable economic impacts of factors in the economy such as technological changes, inflation or deflations.
“…accountability presumes a relationship between two parties, namely someone (an accountor) is accountable to someone else (an accountee) for his activities and their consequences. The accountability relationship may be created by a constitution, a law, a contract, an organisational rule, a custom, or even by an informal moral obligation. A corporation is accountable to its shareholders, creditors, employees, customers, the government, or the public in general based on a variety of relationships created between them. In this sense, it would not be an exaggeration to say that our present society is founded upon accountability networks. An accountant joins the accountability relationship between an accountor and an accountee as a third party. The term accountant includes not only an actual bookkeeper, but also an auditor and any authoritative body which defines accounting principles, such as the Financial Accounting .Standards Board. The primary role of the accountant is to assist the accountor in accounting for his activities and their consequences and, at the same time, provide information to the accountee. Thus, an accountant has a dual relationship, one with the accountor and the other with the accountee.”
Management accountability is of very great interest not only to existing shareholders and other users but also to potential shareholders, creditors and users. A company generally offers shares, debentures etc., to the prospective investing public and therefore it should accept accountability responsibilities to prospective investors also. Certainly annual and other financial statements is intended to play a major role in this regard.
It should be noted that accountability is a broad term that encompasses stewardship. Stewardship traditionally refers to the safe-keeping of resources and the execution of plans for conserving and utilizing them. Management accountability extends beyond the element of stewardship involved in the safekeeping of assets entrusted to custody. It covers modern performance issues based on efficiency and effectiveness notions.
The management accountability concept includes information about future activities, budgets, forecast financial statements, capital expenditure proposal etc. Accountability is beyond the narrow limits of companies’ regal responsibilities to shareholders (and sometimes debenture-holder and creditors).
It obviously includes the interests of persons other than existing shareholders. Management is accountable for the values of assets as well as for their costs. In this way, the financial statements not only inform but also protect the various interests of the shareholders and other users.
There is a school of thought which contends that financial accounting and reporting based on ‘decision-making’ may differ from financial accounting and reporting based on ‘accountability objective’.
This is because decision-making objective and accountability objective differ from each other in some respects such as the following:
Firstly, ‘economic decision-making objective’ focus on the contents of financial statements and how the information reported therein are useful to economic decisions. This objective emphasises more the reliability of information than the accounting system used in producing financial statements.
For instance, cash balance appearing on a balance sheet, if it reflects actual cash balance, will contribute to the decision-making objective and it is immaterial whether cash balance has been determined on the basis of cash book or after mere cash count at the end of an accounting period.
On the other hand, ‘management accountability objective’ mainly emphasises accounting system and procedures used in producing financial statements and other related information. It implies that financial statement figures are supported by adequate documents, records and system.
Secondly, the decision-making objective assumes that the accountant should aim at serving the decision-makers’ informational requirements. That is, his task is to design an information system which is most useful to users in helping them to make sound decisions.
The accomplishment of accountability objective involves a conflict of interests between the accountor and the accountee with regard to the extent of disclosure and method of performance measurement. The accounting system, which is stressed in accountability objective, needs to be evaluated in dual aspects, its relation to the accountor and its relation to the accountee, and the need to resolve the conflicting pressures equitably.
Thirdly, the two objectives—decision-making and accountability—influence the accountor’s interest differently with respect to information reported, especially information relating to accountor’s performance. The decision objective tends to encourage subjective information assuming that it will be unbiased.
The accountability objective anticipates the pressure to bias the information and attempts to establish a system that is strong enough to withstand such pressure. Not just unbiased information, but ‘unbiasable’ information is what ultimately aimed for in the accountability approach.
Contrary to above, there is another school of opinion which does not favour any distinction between the two objectives. A question arises: why distinguish between these functions of accounting and reporting? Are the distinctions superfluous? It would seem that accounting reports on management’s fulfilment of their responsibility to outside owners (the old stewardship notion) would have always necessitated considering management’s effectiveness and efficiency (the new in-formativeness role).
Nevertheless’ accounting’s role in in-formativeness and efficiency, in a social context, has been increasingly emphasized by the profession.
The AICPA frames these relationships in the following way:
“Financial statements are often audited by independent accountants for the purpose of enhancing confidence in their reliability…. Well-developed securities markets tend to allocate scarce resources to enterprises that use them efficiently and away from enterprises that use them inefficiently…. Financial reporting is intended to provide information that is useful in making reasoned choices among alternative uses of scarce resources in the conduct of business activities”.
These views, reiterated by FASB pronouncement (1978), IASC (July 1989), have formed the basis of accounting objectives, practices, standards, and principles into the 1 990s.
As is apparent from these statements, the informational role of accounting is regarded as a crucial link in the efficient allocation of society’s resources by individuals, enterprises, and government. The recent emphasis on the role of accounting in the efficient allocation of resources has been classified under the user-in-formativeness approach.
To conclude, the above two basic objectives associated with company financial reporting contribute in making wise economic decisions and determining the economic performance.
Both these objectives lead to broader social goals, of efficient allocation of investment funds and proper selection among alternative investment opportunities. Thus, accomplishment of these financial reporting objectives influence capital formation and flow of funds and perform a vital role in the successful functioning of an economy.
Developments on Financial Reporting Objectives:
The subject of financial reporting objectives has been generally recognised as very important in accounting area since a long time. Many accounting bodies and professional institutes all over the world have made attempts to define the objectives of financial statements and financial reporting which are vital to the development of financial accounting theory and practice.
This section describes developments in this area at the international level, particularly USA and UK. It can be rightly said that most of the attempts in the area of financial reporting objectives has been made in USA and UK and accounting developments in these countries have great impact on accounting developments and practices in other countries of the world.
Accounting Principles Board (APB) Statement No. 4:
In USA, the APB Statement No. 4 “Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises”, ( 1970) was the first publication which formulated the objectives of financial statements.
These objectives may be summarised as follows:
1. The particular objectives of financial statements arc to present fairly, and in conformity with generally accepted accounting principles, financial position, results of operations, and other changes in financial position.
2. The general objectives of financial statements are:
(a) to provide reliable information about economic resources and obligations of a business enterprise in order to:
(i) Evaluate its strengths and weakness,
(ii) Show its financing and investment,
(iii) Evaluate its ability to meet its commitments, and
(iv) Show its resource base for growth;
(b) To provide reliable information about changes in net resources resulting from a business enterprise’s profit-directed activities in order to:
(i) Show to investors expected dividend return,
(ii) Show the operation’s ability to pay creditors and suppliers, provide jobs for employees, pay taxes, and generate funds for expansion,
(iii) Provide management with information for planning and control, and
(iv) Show its long-term profitability;
(c) To provide financial information useful for estimating the earnings potential of the firm;
(d) To provide other needed information about changes in economic resources and obligations; and
(e) To disclose other information relevant to statement users’ needs.
3. The qualitative objectives of financial accounting are the following:
(a) Relevance, which means selecting the information most likely to aid users in their economic decisions.
(b) Under-stand-ability, which implies not only that the selected information must be intelligible but also that the users can understand it.
(c) Verifiability, which implies that the accounting results may be corroborated by independent measurers using the same measurement methods.
(d) Neutrality, which implies that the accounting information is directed towards the common needs of users rather than the particular needs of specific users.
(e) Timeliness, which implies an early communication of information to’ avoid delays in economic decision-making.
(f) Comparability, which implies that differences should not be the result of different financial accounting treatments.
(g) Completeness, which implies that all the information that ‘reasonably’ fulfils the requirements of other qualitative objectives should be reported.
To develop objectives of financial statements, a Study Group was appointed in 1971 by American Institute of Certified Public Accountants under the Chairmanship of Robert M. Trueblood. The Study Group solicited the views of more than 5000 corporations, professional firms, unions, public interest groups, national and international accounting organisations and financial publications.
The Study Group conducted more than 50 interviews with executives from all sectors of the business and from government. To elicit the widest possible range of views, 35 meetings were held with institutional and professional groups representing major segments of the US economy.
The Study Group submitted its report to AICPA in October 1973. The objectives developed in the Study Group Report are as follows:
1. The basic objective of financial statements is to provide information useful for making economic decisions.
2. An objective of financial statements is to serve, primarily, those users who have limited authority, ability, or resources to obtain information and who rely on financial statements as their principal source of information about an enterprise’s economic activities.
3. An objective of financial statements is to provide information useful to investors and creditors for predicting, comparing and evaluating potential cash flows to them in terms of amount, timing and related uncertainty.
4. An objective of financial statements is to provide users with information for predicting, comparing, and evaluating enterprise earning power.
5. An objective of financial statements is to supply information useful in judging management’s ability to utilise enterprise resources effectively in achieving the primary enterprise goal.
6. An objective of financial statements is to provide factual and interpretative information about transactions and other events which is useful for predicting, comparing and evaluating enterprise earning power. Basic underlying assumptions with respect to matters subject to interpretation, evaluation, prediction, or estimation should be disclosed.
7. An objective is to provide a statement of financial position useful for predicting, comparing and evaluating enterprise earning power. This statement should provide information concerning enterprise transactions and other events that are part of incomplete earning cycles. Current values should also be reported when they differ significantly from historical costs. Assets and liabilities should be grouped or segregated by the relative uncertainty of the amount and timing of prospective realisation of liquidation.
8. An objective is to provide a statement of periodic earnings useful for predicting, comparing and evaluating enterprise earning power. The net result of completed earning cycles and enterprise activities resulting in recognisable progress towards completion of incomplete cycles should be reported. Changes in values reflected in successive statements of financial position should also be reported, but separately, since they differ in terms of their certainty realisation.
9. An objective is to provide a statement of financial activities useful for predicting, comparing, and evaluating enterprise earning power. This statement should report mainly on factual aspects of enterprise transactions having or expected to have significant cash consequences. This statement should report data that require minimal judgement and interpretation by the compiler.
10. An objective of financial statements is to provide information useful for the predictive process. Financial forecasts should be provided when they will enhance the reliability of users’ predictions.
11. An objective of financial statements for governmental and non-profit organizations is to provide information useful for evaluating the effectiveness of management of resources in achieving the organisation’s goals. Performance measures should be qualified in terms of identified goals.
12. An objective of financial statements is to report on those activities of the enterprise affecting society which can be determined and described or measured and which are important to the role of the enterprise in its social environment.
The twelve objectives recommended in the report seem to fall into five tiers as described in Fig 10.1. Tier I is the basic objective which underlies all financial reporting. Tier II objectives identify the financial statement users and their needs. Tier III objectives translate users’ needs in terms of enterprise.
Tier IV objectives describe information about the enterprise which satisfied or is presumed to satisfy users’ needs. Tier V objectives concern skeletal financial statements directed at communicating the information identified by the objectives in Tier IV.
The Corporate Report (UK):
The Accounting Standards Steering Committee of the Institute of Chartered Accountants in England and Wales Published ‘The Corporate Report’ in 1976 as a discussion paper covering the scope and aims of published financial reports, public accountability of economic entities, working concepts as a basis for financial reporting, and most suitable means of measuring and reporting the economic position, performance and prospects of undertakings.
The Corporate Report’s main findings are as follows:
First, the basic philosophy and starting point of The Corporate Report is that financial statements should be appropriate to their expected use by potential users. In others words, they should attempt to satisfy the information needs of their users.
Second, the report assigned responsibility for reporting to the ‘economic entity’ having an impact on society through its activities. The economic entities are itemized as limited companies, listed and unlisted; pension schemes, charitable and other trusts, and not-for-profit organisation; non-commercially oriented Central Government departments and agencies, partnerships and other forms of un-incorporate business enterprises; trade unions and trade and professional association; local authorities, and nationalized industries and other commercially oriented public sector bodies.
Third, the report defined users as those having a reasonable right to information and whose information needs should be recognised by corporate reports. The users are identified as the equity investor group, the loan creditor group, the employee group, the analyst-adviser group, the business contact group, the government, and the public.
Fourth, to satisfy the fundamental objectives of annual reports set by the basic philosophy, seven desirable characteristics are cited, namely, that the corporate report be relevant, understandable, reliable, complete, objective, timely, and comparable.
Fifth, after documenting the limitations of current reporting practices, the report suggests the need for the following additional statements:
1. A statement of value added, showing how the benefits of the efforts of an enterprise are shared among employees, providers of capital, the state and reinvestment.
2. An employment report, showing the-size and composition of the work force relying on the enterprise for its livelihood, the work contribution of employees, and the benefits earned.
3. A statement of money exchange with government, showing the financial relationship between the enterprise and the state.
4. A statement of transactions in foreign currency, showing the direct cash dealing, between the United Kingdom and other countries.
5. A statement of future prospects, showing likely future profit, employment, and investment levels.
6. A statement of corporate objectives showing management policy and medium-term strategic targets.
Finally, after assessing six measurement bases (historical cost, purchasing power, replacement cost, net realisation value, value to the firm, and net present value) against three criteria (theoretical acceptability, utility, and practicality) the report rejected the use of historical cost in favour of current values accompanied by ;he use of general index adjustment.
FASB Concept No. 1:
Probably the most comprehensive statement on objectives of financial reporting is FASB (USA) Concept No. 1 “Objectives of Financial Reporting by Business Enterprises” issued in November 1978 by US Financial Accounting Standards Board.
The objective of financial reporting developed in this statement are the following:
Financial reporting should provide information that is useful to present and potential investors, creditors and other users in making rational investment, credit, and similar decisions. The information should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence.
Financial reporting should provide information to help present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts from dividends or interest and the proceeds from the sale, redemption, or maturity of securities or loans.
The prospects for those cash receipts are affected by an enterprise’s ability to generate enough cash to meet its obligations when due and its other cash operating needs, to reinvest in operations, and to pay cash dividends, and may also be affected by perceptions of investors and creditors generally about that ability, which affect market prices of the enterprise’s securities.
Thus, financial reporting should provide information to help investors, creditors, and others assess the amount, timing and uncertainty of prospective net cash inflows to the related enterprise .
Financial reporting should provide information about the economic resources of an enterprise, the claims to those resources (obligations of the enterprise to transfer resources to other entities and owners’ equity), and the effects of transactions, events, and circumstances that change resources and claim to those resources.
Financial reporting should provide information about an enterprise’s financial performance during a period. Investors and creditors often use information about the past to help in assessing the prospects of an enterprise.
Thus, although investment and credit decisions reflect investors’ and creditors’ expectations about future enterprise performance, those expectations are commonly based at least partly on evaluations of past enterprise performance.
The primary focus of financial reporting is information about an enterprise’s performance provided by measures of earning and its components. Financial reporting should provide information about how an enterprise obtains and spends cash, about its borrowing and repayment of borrowing, about its capital transactions, including cash dividends and other distribution of enterprise resources to owners, and about other factors that may affect an enterprise’s liquidity or solvency.
Financial reporting should provide information about how management of an enterprise has discharged its stewardship responsibility to owners (stockholders) for the use of enterprise resources entrusted to it.
Financial reporting should provide information that is useful to managers and directors in making decisions in the interests of owners.
Besides the above objectives, the FASB Concept No. 1 contains the following important highlights:
1. Financial reporting is not an end in itself but is intended to provide information that is useful in making business and economic decisions.
2. The objectives of financial reporting are not immutable—they are affected by the economic, legal, political and social environment in which financial reporting takes place.
3. The objectives are also affected by the characteristics and limitations of the kind of information that financial reporting can provide.
(i) The information pertains to business enterprises rather than to industries or the economy as a whole.
(ii) The information often results from approximate, rather than exact, measures.
(iii)The information largely reflects the financial effects of transactions and events that have already happened.
(iv) The information is but one source of information needed by those who make decisions about business enterprises.
(v) The information is provided and used at a cost.
4. The objectives in this Statement (Concept No. 1) are those of general purpose external financial reporting by business enterprises.
(i) The objectives stem primarily from the needs of external user-e who lack the authority to prescribe the information they want and must rely on information management communicates to them.
(ii) The objectives are directed toward the common interest of many users in the ability of an enterprise to generate favourable cash flows but are phrased using investment and credit decisions as a reference to give them a focus. The objectives are intended to be broad rather than narrow.
(iii) The objectives pertain to financial reporting and are not restricted to financial statements.
5. ‘Investors’ and ‘Creditors’ are used broadly and include not only those who have or contemplate having a claim to enterprise resources but also those who advise or represent them.
6. Although investment and credit decisions reflect investors’ and creditors’ expectations about future enterprise performance, those expectations are commonly based at least partly on evaluations of past enterprise performance.
7. The primary focus of financial reporting is information about earnings and its components.
8. Information about enterprises earning based on accrual accounting generally provides a better indication of an enterprise’s present and continuing ability to generate favourable cash flows than information limited to the financial effects of cash receipts and payments.
9. Financial reporting is expected to provide information about enterprises financial performance during a period and about how management of an enterprise has discharged its stewardship responsibility to owners.
10. Financial accounting is not designed to measure directly the value of a business enterprise, but the information it provides may be helpful to those who wish to estimate its value.
11. Investors, creditors, and others may use reported earnings and information about the elements of financial statements in various ways to assess the prospects for cash flows. They may wish, for example, to evaluate management’s performance, estimate ‘earning power’, predict future earnings, assess risk, or to confirm, change, or reject earlier predictions or assessments. Although financial reporting should provide basic information to aid them, they do their own evaluating, estimating, predicting, assessing, confirming, changing, or rejecting.
12. Management knows more about the enterprise and its affairs than investors, creditors, or other ‘outsiders’ and accordingly can often increase the usefulness of financial information by identifying certain events and circumstances and explaining their financial effects on the enterprise.
CICA’s Stamp Report:
The Canadian Institute of Chartered Accountants (CICA) published a report in June 1980 on ‘Corporate Reporting: Its Future Evolution’ which was written by Edward Stamp.
Popularly known as Stamp Report, it mentions the following as the important objectives of company financial reporting:
1. One of the primary objectives of published corporate financial reports is to provide an accounting by management to both equity and debt investors, not only a management’s exercise of its stewardship function but also of its success (or otherwise) in achieving the goal of producing a satisfactory economic performance by the enterprise and maintaining it in a strong and healthy financial position.
2. It is an objective of good financial reporting to provide such information in such a form as to minimise uncertainty about the validity of information, and to enable the user to make his own assessment of the risks associated with the enterprise.
3. It is necessary that the standards governing financial reporting should have ample scope for innovation and evolution as improvements become feasible.
4. The objectives of financial reporting should be taken to be directed towards the need of users who are capable of comprehending a complete (and necessarily sophisticated) set of financial statements or alternatively, to the needs of experts who will be called on by the unsophisticated users to advise them.
The Stamp Report has not found FASB’s Conceptual Framework and objectives on financial reporting suitable and useful for Canada because of the environmental difference between USA and Canada. This is true not only in case of any particular country but applicable equally to other countries as well.
Financial reporting— its objectives and scope— are influenced by the economic, legal, political, institutional and social factors prevailing in a country. Therefore, these factors need to be considered before developing financial reporting objectives in any country.
Users in Financial Reporting:
The company financial reporting is intended to provide external users information that is useful in making business and economic decisions, that is, for making reasoned choices among alternative uses of scarce resources in the conduct of business and economic activities. Thus, users are potentially interested in the information provided by financial reporting.
Among the potential users are owners, lenders, suppliers, potential investors and creditors, employees, management, directors, customers, financial analysts and advisors, brokers, stock exchanges, lawyers, economists, taxing authorities, regulatory authorities, legislators, financial press and reporting agencies, labour unions, trade associations, business researchers, teachers and students, and the public.
Some users—such as owners, creditors, and employees—have or contemplate having direct economic interests in particular business enterprises. Managers and directors, who are charged with managing the enterprise in the interest of owners, also have a direct interest.
Some users— such as financial analysts and advisors, regulatory authorities, and labour unions—have indirect interests because they advise or represent those who have or contemplate have direct interests.
Potential users of financial information most directly concerned with a particular business enterprise are generally interested in its ability to generate favourable cash flows because their decisions relate to amounts, timing, and uncertainties of expected cash flows.
To investors, lenders, suppliers, and employees, a business enterprise is a source of cash in the form of dividends or interest and, perhaps, appreciated market price, repayment of borrowing, payment of goods or services, or salaries or wages.
They invest cash, goods, or service in an enterprise and expect to obtain sufficient cash in return to make the investment worthwhile. To customers, a business enterprise is a source of goods or services, but only by obtaining sufficient cash, to pay for the resources it uses and to meet its other obligations, can the enterprise provide those goods or services.
To managers, the cash flows of a business enterprise are a significant part of their management responsibilities, including their accountability to directors and owners. Many, if not most, of their decisions have cash flow consequences for the enterprise.
Thus, investors, creditors, employees, customers, and managers significantly share a common interest in an enterprise’s ability to generate favourable cash flows. Other potential users of financial information share the same interest, derived from investors; creditors, employees, customers, or managers whom they advise or represent or derived from an interest in how those groups (and especially shareholders) are fair.
Some of the potential users listed above may have specialised needs but also have the power to obtain the information needed. For example, the information needed to enforce tax laws and regulations are specialised needs.
However, although the taxing authorities often use the information in financial statements for their purposes, they also have statutory authority to require the specific information they need to fulfill their functions, and do not need to rely on information provided to other groups.
Some investors and creditors or potential investors and creditors may also be able to require a business enterprise to provide specified information to meet a particular need. For example, a bank or insurance company negotiating with an enterprise for a large loan or purchase of securities can often obtain desired information by making the information a condition for completing the loan transaction.
Some users of financial information can obtain more information about an enterprise than others. This is clearly so for managers, but it also holds true for others, such as large scale equity shareholders and creditors. Financial statements are, it is argued, especially important to those who have limited access to information and limited ability to interpret it.
The True-blood Report states:
“An objective of financial statements is to serve primarily those users who have limited authority, ability, or resources to obtain information and who rely on financial statements as their principal source of information about an enterprise’s economic activities.”
Financial Accounting Standards Board (USA) does not agree with True-blood’s concept of users for financial reporting. According to FASB, financial reporting information should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence. FASB argues:
“Individual investors, creditors, or other potential users of financial information understand to varying degrees the business and economic environment, business activities, securities markets, and related matters. Their understanding of financial information and the way and extent to which they use and rely on it also may vary greatly. Financial information is a tool and, like most tools, cannot be of much direct help to those who are unable or unwilling to use it or who misuse it. Its use can be learned, however, and financial reporting should provide information that can be used by all—non-professionals as well as professionals—who are willing to learn to use it properly. Efforts may be needed to increase the understandability of financial information. Cost benefit considerations may indicate that information understood or used by only a few should not be provided Conversely, financial reporting should not exclude relevant information, merely because it is difficult for some to understand or because some investors or creditors choose not to use it”.
In India, the basic purpose of financial reporting (as per Indian Companies Act, 1956) is to provide shareholders of the company, financial statements and other related information. In India, shareholders, especially the existing shareholders, are the primary users of financial reporting.
However, there are other potential users also who are equally interested in financial reporting information for making economic decisions. Therefore, the purpose of financial reporting in India should be to serve not only existing investors but prospective investors and creditors, and other external users and stakeholders as well.
General Purpose Financial Reporting:
Generally speaking, the term ‘financial reporting’ is used to mean general purpose external financial reporting. Often it is said that the purpose of financial reporting is the preparation of general purpose reports for external users. Despite the fact that financial reports are mainly intended (legally) for shareholders, they can be, and are, used by a number of other external users
The users of financial statements include present and potential investors, employees, lenders, suppliers and other trade creditors, customers, governments and their agencies and the public. They use financial statements in order to satisfy some of their different needs for information.
These needs include the following:
The providers of risk capital and their advisors are concerned with the risk inherent in, and return, provided by their investments They need information to help them determine whether they should buy, hold or sell. Shareholders are also interested in information which enables them to assess the ability of the enterprise to pay dividends.
Employees and their representative groups are interested in information about the stability and profitability of their employers. They are also interested in information which enables them to assess the ability of the enterprise to provide remuneration, retirement benefits and employment opportunities.
Lenders are interested in information that enables them to determine whether their loans, and the interest attaching to them, will be paid when due.
(d) Suppliers and other trade creditors:
Suppliers and other creditors are interested in information that enables them to determine whether amounts owing to them will be paid when due. Trade creditors are likely to be interested in an enterprise over a shorter period than lenders unless they are dependent upon the continuation of the enterprise as a major customer.
Customers have an interest in information about the continuance of an enterprise, especially when they have a long-term involvement with, or are dependent on, the enterprise.
(f) Governments and their agencies:
Governments and their agencies are interested in the allocation of resources and, therefore, the activities of enterprises. They also require information in order to regulate the activities of enterprises, determine taxation policies and as the basis for national income and similar statistics.
Enterprises affect members of the public in a variety of ways. For example, enterprises may make a substantial contribution to the local economy in many ways including the number of people they employ and their patronage of local suppliers. Financial statements may assist the public by providing information about the trends and recent developments in the prosperity of the enterprise and the range of its activities.
While all of the information needs of these users cannot be met by financial statements, there are needs which are common to all users. As investors are providers of risk capital to the enterprise, the provision of financial statements that meet their needs will also meet most of the needs of other users that financial statements can satisfy.
The management of an enterprise has the primary responsibility for the preparation and presentation of the financial statements of the enterprise. Management is also interested in the information contained in the financial statements even though it has access to additional management and financial information that helps it carry out its planning, decision-making and control responsibilities.
Management has the ability to determine the form and content of such additional information in order to meet its own needs. The reporting of such information, however, is beyond the scope of this framework. Nevertheless, published financial statements are based on the information used by management about the financial position, performance and changes in financial position of the enterprise.
It is still debatable whether a single set of financial statements could serve the interests of all external users. It is possible that some users may find the financial reports more useful than the others. However, it has been forcefully argued and empirically proved that all external users have something in common while making investment decisions and fulfilling their needs.
Therefore, although the users may be of different types, they have certain similar information needs. The question of similar information needs of investors and creditors is best understood in terms of their economic decisions, i.e.., investment decision and credit decision.
Investment decision concerns the decision to buy, to sell or to hold a share. An investment decision is a complex one because of intervention of investment market. An investor in a buying decision determines the ability of an enterprise to pay dividends, currently, prospectively or even at liquidation. In an investment market share prices rise and fall with changes in investors’ expectations about the ability of an enterprise to pay further dividends.
In a credit decision, the lender knows the amount of loan requested and the terms of repayment of principal and interest. The lender receives a definite amount of interest or return.
The lender seeks to determine the borrower’s ability to repay principal and interest. The borrower’s ability to pay is not subject to precise measurement and in most situations, no single set of information can provide the lender with an assured measure of the borrower’s ability to repay.
Thus, the credit decisions like other economic decisions, require an assessment of risk. Therefore, adequate information is needed by the lender to be selective among borrowers (to reduce his risk) and to make predictions based on his preferences for amount, timing, and uncertainty of cash returns. Lenders also need information about borrowers to determine the degree of control or influence they wish to impose through such loan provisions.
All investors and creditors measure sacrifices and benefits in terms of the actual or prospective disbursement or receipt of cash. The distinction between an investment and a credit decision, often, is not sharp. Thus, the information needs of creditors and investors are essentially the same.
Both groups are concerned with the enterprise’s ability to generate cash flows to them and with their own ability to predict, compare, and evaluate the amount, timing, and related uncertainty of these future cash Flow.
The Statement of Financial Accounting Concept No. 1 of FASB (USA) also states that “general purpose external financial reporting is directed toward the common interest of various potential users in the ability of an enterprise to generate favourable cash flows”. It is also contended that investors and creditors and their advisers are the most obvious prominent external groups who use the information provided by financial reporting.
Their decisions and their uses of information are usually studied and described to a much greater extent than those of other external groups, as their decisions significantly affect the allocation of resources in the economy. In addition, information provided to meet investors’ and creditors’ needs is likely to be generally useful to members of other user groups who are interested in essentially the same financial aspects of business enterprises as investors and creditors.
Management as user of information is as interested in information about assets, liabilities, earnings, and related elements as external users are, and need, generally, the same kind of information about these elements as external users. Thus, management is major user of the same information that is provided by external financial reporting.
However, management’s primary role in external financial reporting is that of communicating information for use by others. For that reason, it has a direct interest in the cost, adequacy, reliability, and, understandability of external financial reporting.
Specific Purpose Report:
Financial reporting objectives in accounting literature so far has focused on general purpose financial reporting which aims to satisfy the information needs of all potential users.
Company law provisions in almost all countries of the world have consistently accepted the utility of general purpose financial reporting. Due to this, the separate (specific) needs of specific users have been largely ignored on the assumption that general purpose reports can satisfy the information needs of all external users.
However, a reasoning has also been made suggesting that the needs of specific users may be better served by presenting specific purpose reports to help them in their separately identifiable decision functions. For instance, financial reports submitted to obtain credit or loans, or government, or financial reports given to trade and industry, may not satisfy other users’ needs and expectations.
However, the proposal of specific purpose reports in company financial reporting is criticised on some counts.
Firstly, the cost of the developing ‘specialised reports to satisfy special requirements of specific users may exceed the benefits when the company financial reporting policy is determined in its totality.
Secondly, specialised needs of specific users cannot be ascertained with any degree of certainty.
Thirdly, issuing multiple reports about the financial results of an enterprise can create confusion among various users. Multiple reports increase the perceived complexity of the environment. Such changes in perceived environment complexity induce changes in decision-makers’ cognitive processing capabilities and, in turn, can decrease the effectiveness of decision-making by users.
Fourthly, multiple reports may not be desirable and practicable from the standpoint of information economics.
To conclude, company financial reporting, in future, will continue to adhere to general purpose reporting system to aid investors, creditors, and other external users in their economic decisions.
Meanwhile, in order to achieve the objectives of financial reporting (through general purpose reports) there is a continuous need to investigate many vital aspects relating to general purpose financial reports such as identifying potential users and user groups, identifying information needs of such users, determining the feasibility of providing general purpose information to meet these needs, determining the manner of reporting such information, and having a feedback from the users regarding the use and relevance of general purpose information.
Benefits of Financial Reporting:
The financial reporting, if adequate and reliable, would be useful in many respects.
Benefits of financial reporting may be listed as follows:
1. Economic Decisions Making:
The ultimate goal of any economy is to maximise the social welfare for which an efficient allocation of resources is required. This goal is of particular significance in developing economies where resources are not plentiful. The availability of capital is one of the scarce and major productive factors needed to pursue economic activity and to achieve the goal of efficient allocation of resources.
Companies compete in the securities market to obtain their capital as easily as possible. Since owners of capital like business enterprises, attempt to maximise their own wealth and well-being, they require information to help them in making sound economic decisions. This process is assumed to lead to the broader social goal of efficient allocation of resources throughout the economy.
Mautz and May observe:
“Financial disclosure is essential to the functioning of a free enterprise economy. One aspect of a market oriented economy is the allocation of capital on a market basis. Financial disclosure is required to support a viable capital market. Indeed, without adequate financial disclosure there is a real question whether significant amounts of capital could be found. In addition, a viable capital market is essential to resource allocation within the economy. It is in the capital market that a major portion of the nation’s resources are allocated to those companies which serve customers effectively, and capital is refused to those companies who do not serve customers effectively.”
The two important economic decisions that influence allocation of resources and which external users usually make are (a) security investment (b) credit decision. Sound economic decisions require assessment of impact of current business activities and developments on the earning power of a company.
Both economic decisions require detailed information to determine benefits (to be received) in lieu of sacrifices (resources given). Information about economic resources and obligations of a business enterprise is also needed to form judgements about the ability of the enterprise to survive, to adapt, to grow, and to prosper amid changing economic conditions.
In this task, financial reporting can provide information important in evaluating the strength and weakness of an enterprise and its ability to meet its commitments. It can supply information about transactions within the business and factors outside the company such as taxation policy, trade restrictions, technological changes, market potentialities etc., which affect the earning power of a business enterprise.
2. Cost of Capital:
Adequate disclosure in annual reports is expected, in the long run, to enhance market price of company’s share in the investment market. Higher prices of company shares resulting from the full disclosure will have a favourable impact on the company’s cost of capital. It also enhances the future marketability of subsequent issue of company’s shares.
Choi argues that if analysts are kept well informed then, over the long run, an individual company’s shares prices will be relatively higher. Higher security prices would mean that a primary security issue could be priced higher and that the net proceeds from the issue would be higher. Thus the firm would experience larger receipt from a given issue and hence experience a lower cost of capital.
A report for Arthur Anderson and Company stated:
“Consistently good financial reporting should have a favourable long run effect on the company’s cost of capital. Over a period of time, good reporting leads to informed investors who, because they understand the company, will pay a fair price for its securities. Minimum or inconsistent reporting often leads to some loss of investors’ confidence in the quality of company information and, ultimately, in the price they will pay in the market. Credibility is a subtle intangible of great importance to any company, corporate reporting practices have a major effect on it. We have often observed this connection between credibility, corporate reporting, and the cost of capital….Good corporate reporting is a long-term policy applicable to good times and bad.”
Some empirical evidence which relate information release to the firm’s market value are presented by, for example, Merton, and Diamond and Verrecchia. In the Merton model, information asymmetry is modelled as only a subset of investors knowing about each firm.
If the firm can increase the size of this subset, say by the voluntary release of information, its market value will rise, other things being equal. In the Diamond and Verrecchia model, voluntary disclosures reduce information asymmetry between the firm and the market which facilitates trading in its shares.
The resulting increase in market liquidity attracts large institutional investors who, if they have to do in future, can sell large blocks of shares without lowering the price they receive. The firm’s share price increases as a result of this greater demand. It should be noted that market efficiency, whereby the markets properly interpret the firm’s information, is assumed in this argument.
Thus data expansion would have a favourable effect on the cost of capital. However, some doubts have been expressed about the disclosure regulation (for increased disclosure) resulting in a lower cost of equity capital. It is argued that managers have strong incentives to minimise the possibility of shareholder unrest by controlling the flow of information to eliminate fluctuations in performance measures, thereby misleading shareholders with respect to the relative riskiness of the firm.
If managers manipulated, or simply did not publish adverse financial data to hide poor performance from investors, subsequent disclosure of such information due to the passage of some regulation might result in lower market price for the related shares and a higher cost of equity capital.
Similarly, if managers attempted to avoid or manipulate disclosure in the hope that this practice would cause investors to perceive the firm to be less risky than it really is, subsequent disclosure might well result in higher risk as perceived by investors.
This increase in perceived risk presumably would result in an increase in the cost of equity capital to the firm. Manipulation and/or misrepresentation, once discovered, will lead to loss of investor confidence in the quality of company information and that, in turn, will lower the price they will for its securities.
Thus, the above discussion implies that a disclosure regulation would be expected to have a favourable effect on the cost of equity capital of the affected firms. Implicit in this discussion is the assumption that a disclosure regulation would result in an improvement in the financial disclosure of the affected firms.
A study conducted by Dhaliwal to examine the impact of disclosure regulations on the cost of equity capital of affected firms concluded that segmental disclosure requirement had a favourable effect on the cost of equity capital because disclosure requirement improved the quality of financial disclosure of affected firms and that, in turn, it reduced uncertainty about their stocks.
3. Equilibrium in Share Prices:
Adequate disclosure will tend to minimise the fluctuations in company’s share prices. Fluctuations in share prices occur because of the ignorance prevailing in the investment market. Fluctuations show an element of uncertainty in investment decisions. If the securities market are in possession of full information, the ignorance and uncertainty will be reduced and share prices will tend to maintain equilibrium.
Besides, increased disclosures would prevent fraud and manipulations and would minimise chances of their occurrences. Additionally all investors would be treated equally as far as the availability of significant financial information is concerned.
Ethics in disclosure demands that no caste system for release of corporate information—telling the sophisticated first and the general public later or not at all—should be followed by corporate managements.
Miller and Bahnson have suggested the following four axioms regarding quality financial reporting:
i. Incomplete information creates uncertainty.
ii. Uncertainty creates for investors and creditors.
iii. Risk makes investors and creditors demand a higher rate of return.
iv. A higher rate of return of investors and creditors is a higher cost of capital for the firm and produces lower security prices.
In a positive perspective and for positive thinkers, the above four axioms can also be stated in the following different terms:
i. More complete information reduces uncertainty.
ii. Less uncertainty reduces risk for investors and creditors.
iii. Reduced risk makes investors and creditors satisfied with a lower rate of return.
iv. A lower rate of return for investors and creditors is a lower cost of capital for the firm and produces higher stock prices.
Figure 10.3 summarizes the axioms and the chain reactions between the information provided to the public and the company’s security prices.
4. Employee Decisions:
Employee decisions may be based on perceptions of a company’s economic status acquired through financial statements. In particular, prospective and present employees may use the financial reports to assess risk and growth potential of a company and therefore, job security and future promotional possibilities.
These decisions affect the allocation of human capital in the economy. Labour unions and individual employees may use financial statement data as a basis for making contractual wage and employment benefit demands. Should this occur, data that incorrectly reflect the economic position and prospects of an enterprise may mislead employees into making or justifying unrealistic demands.
Furthermore, unionized companies showing large increases in earnings are likely to be faced with successfully negotiated demands for large wage increases.
Hence, as regards employee decisions, accounting techniques that result in greater fluctuations in reported earnings appear to be costly to shareholders, sharp increases in profits are likely to generate demands for large wage increases, while sharp decreases may lead to employee fears of bankruptcy or financial difficulties.
Management also want to avoid charges of manipulation of net profit data. Thus, an apparently objectively determined series that tends not to change sharply is desirable. Historical cost based accounting meets these requirements.
5. Customer Decisions:
The data presented in financial statements may affect the decision of a company’s customers and hence have economic consequences. Customers, like employees, may use financial statement data to predict the likelihood and/or timing of a firm going bankrupt or being unable to meet its commitments.
This information may be important in estimating the value of a warranty or in predicting the availability of supporting services or continuing supplies of goods over an extended period of time.
Financial institutions also may use the financial statements to assess their present and future solvency and hence, the likelihood that they will be able to repay funds or meet promises as contracted. It is likely that the sophisticated customers will be able to see through arbitrary or misleading accounting practices.
Unsophisticated customers, however, may be misled by accounting procedures, particularly when newly adopted procedures result in sudden changes in reported data. With respect to customer decisions the economic consequences of accounting procedures are likely to be limited to the period of uncertainty that occurs when a change is instituted. Even then, sophisticated customers are not likely to misinterpret the change.
6. Manager’s Decisions:
The accounting data published in financial reports may have economic effects through its impact on the behaviour of the managers of corporate enterprises. The inclusion of accounting numbers in management compensation schemes or the fear of market misinterpretation of accounting reports may influence a manager’s operating and financing decisions.
Shareholders prefer accounting procedures that mirror economic events as closely as possible. However, shareholders also must be concerned that the managers might manipulate the reported data to increase their compensation.
Therefore, shareholders, like creditors and union leaders, also want numbers that are reliable and objectively determined Considering the problems of obtaining measurements of income and net worth that are both objectively determined and valid representations of economic reality, it seems likely that management and shareholders would adopt compensation schemes that recognise the limitations of the data, such that the expected payments conform to the market price for managerial services.
To sum up, information contributes much towards better investment decision making, promoting understanding and creating an environment to cooperate.
Financial reporting generates confidence and has favourable effect on the company’s cost of capital. In the long run, financial reporting can retain its credibility only if it does what it is designed to do—provide society with relevant and reliable information about economic events and transactions—and does not attempt to move the economy in one direction rather than another.