Corporate Financial Reporting

Theory and Practice

Andrew Higson

• Publisher: SAGE Publications Ltd
• Year: 2002
• Print ISBN: 9780761971412, 9780761971405
• eBook ISBN: 9781446229620
• Edition: 1
• Topic: Business
• Subtopic: Financial Accounting
• Index: Business

`This is a book which should be read by all students, whether undergraduate and postgraduate. It also provides a succinct guide for the manager who wishes to come to grips with this topic, or the accountant nostalgic to recollect the non too praiseworthy and indecisive history of this topic? - Managerial Auditing Journal

Corporate Financial Reporting critically examines contemporary corporate financial reporting. The complexity of the reporting process and the myriad of issues facing the directors, accountants and auditors can only be successfully understood from a firm conceptual base. Recent financial scandals clearly highlight the interrelationships between all the themes explored in this book, from financial reporting to auditing, from management?s motivations to fraud.

Special features of this book include:

- A critical examination of accounting ?theory?

- Senior practitioners? insights on ?a true and fair view?

- An exploration of ?the financial reporting expectations gap?

- A discussion of the nature of ?corporate performance?

- An examination of corporate fraud

- An examination of the implications of ?real-time? reporting by companies

- Discussion questions at the end of each chapter

The book will be relevant to advanced undergraduate as well as postgraduate and MBA students.

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1	Issues in Financial Reporting

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The path to knowledge cannot be found without visions and an overall picture.

– R. Mattessich

Today’s dynamic business environment is heralding a revolution in the need for, and the way in which, accounting data is utilized. This has resulted in talk of ‘an accounting revolution’ (Beaver, 1998) and the possible ‘redefinition of accountancy’ (Elliott, 1998: 7). However, it is all too easy to become caught up in this stampede for change, but how far can accounting change and for it still to be called accounting?

This chapter seeks to explore the major issues facing contemporary financial reporting – this will include its interrelationship with external auditing and the provision of assurance to those outside the reporting entity. After all, ‘[e]ffective reporting and accounting, and external scrutiny from auditors, are essential for effective corporate governance’ (Company Law Review Steering Committee, 2001: para. 8.1). To understand the financial statements, one needs to appreciate the auditors’ work and opinion, and, conversely, to understand the auditors’ work and opinion, it is necessary to appreciate the scope and limitations of the financial statements. All too often, financial reporting and external auditing are treated and discussed in isolation despite being inextricably linked. However, the final figures in the financial statements may come about as a result of negotiations between management and their auditors – with the auditors examining the reasonableness of management’s justifications for their representations. Indeed, the modern audit with its emphasis on high-level business risks could almost be viewed as the ‘audit of motivations’ – to understand the figures in the financial statements, it is important to understand management’s motivations. Financial reporting and auditing are not just technical subjects, but they encompass a multitude of judgements and assumptions. This may go some way to explain why it is possible for a company to collapse not long after the publication of a set of accounts with an unqualified audit opinion. Auditing is not just about vouching the contents of the accounting records – it is just as important to understand accounting data in context. Therefore, this book explicitly recognizes and seeks to explore the interdependences between financial reporting and auditing.

THE SCOPE OF THE PROBLEMS FACING FINANCIAL REPORTING

The changes taking place in the commercial environment have resulted in the accountancy profession critically reviewing its role and the relevance of its curriculum. A number of these developments in the commercial world are set out by Albrecht and Sack (2000: 5–6):

• technological developments resulting in the inexpensive preparation and dissemination of information, thus decreasing the cost and expertise necessary to produce the financial statements
• the globalization of business arising from ‘instantaneous information’ in tandem with quick and reliable methods of transportation
• the growth in pension funds and other institutional investors with a resultant increase in their power to influence businesses.

Albrecht and Sack quote a participant in their study as summarizing the situation as follows:

We are moving into an age of instant gratification – that seems to be true whether it’s children, clients, or whatever – they want instant gratification and you have to provide the answers now! We not only have to provide the answers, but the right answers. As companies change, they can’t get information fast enough and if they can’t get it from us [accountants], they will get it somewhere else. (2000: 6)

This concern may be exacerbated by the view expressed by the US Accounting Principles Board (APB, 1970: para. 40) that ‘[a]ccounting is a service activity’. It considered that the function of accounting ‘is to provide quantitative information primarily financial in nature about economic entities that is intended to be useful in making economic decisions, in making resolved choices among alternative courses of action’ (para. 40). This is very different from a definition in 1941 that stated: ‘Accounting is an art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character, and interpreting the results thereof’ (cited by the American Institute of Accountants’ Committee on Terminology, 1953: 9). This change in definition shows that the concern about accounting and financial reporting being left behind as the business world develops is not a new phenomenon.

The major driving forces behind the developments in contemporary financial reporting include the following.

Globalization

This has given rise to the push for the international harmonization of accounting standards and the resultant debate about whose standards should be adopted. In the European Union, by 2005 publicly traded EU incorporated companies will have to follow the international financial reporting standards of the International Accounting Standards Board (IASB) – formerly the International Accounting Standards Committee (IASC). Over the final quarter of the twentieth century, there was increasing recognition of the politicization of the standards-setting process (Armstrong, 1977; Solomons, 1978; Zeff, 2002) and the implications of the economic consequences of accounting standards and policies (Zeff, 1978). Therefore, the adoption of international standards needs to be viewed as much in a political context as in an accounting one. However, ‘[i]nternational accounting standard-setting is currently in crisis’ (Horton and Macve, 2000: 26).

The influence of management

This is a critical constituency when it comes to developments in accounting: ‘Management is central to any discussion of financial reporting, whether at the statutory or regulatory level, or at the level of official pronouncements of accounting bodies’ (Moonitz, 1974: 64). One of the reasons for the failure of the current cost experiment in the early 1980s was the lack of support from financial statement preparers (they were not convinced of the validity of the exercise). Current values are now starting to creep into the financial statements, and ‘[s]ome corporate executives concerned about the volatility of reported results have claimed that standard-setters have a hidden agenda to undermine the bedrock of historical cost by introducing piecemeal requirements for current value measurement’ (Miller and Loftus, 2000: 5). There is a concern that the standard setters may be requiring data for external reporting that management does not find useful for its own internal uses. The debacle regarding current cost accounting in the 1980s should not be forgotten.

Extreme market pressures

The pressures from the capital markets are forcing management to achieve earnings targets:

These pressures are exacerbated by the unforgiving nature of the equity market as securities valuations are drastically adjusted downward whenever companies fail to meet ‘street’ expectations. Pressures are further magnified because management’s compensation often is based in large part on achieving earnings or other financial goals. (Panel on Audit Effectiveness, 2000: 3)

One consequence of these market pressures is the danger of ‘aggressive earnings management’ that ‘results in stakeholders, and the capital markets generally, being misled to some extent about an entity’s performance and profitability’ (Auditing Practices Board, 2001: 3). Recent financial scandals may be viewed as coming about as a result of extreme disclosure and earnings management.

The informational perspective of the financial statements

The emphasis is now on the provision of information to enable the users of the financial statements to take decisions and to make assessments of future cash flows of the reporting entity. Since the 1960s, users have been actively involved in dialogue about accounting principles and are represented on some accounting standard-setting bodies. ‘An outsider, however, might find it remarkable that accounting knowledge should be articulated not only by professional accountants, but also by accounting information users – much like doctors and patients collaborating on the development of medical knowledge’ (Hines, 1989: 80). In 1994, the AICPA issued a report containing the findings of a special committee aimed at improving business reporting. The intention was to ‘influence future agendas of standard setters and regulators and the direction of their projects’. Its adoption of ‘a customer focus’ orientation was explained as follows:

Just as successful businesses align the features of their products and services with the needs of their customers, so, too, should the providers of business reporting. Recognizing this, the Committee concentrated on the information needs of users to help identify and evaluate ideas for improvement. (AICPA, 1994: 4)

The user-primacy, decision-oriented view has not gone unchallenged, and it may have resulted in unrealistic expectations about what the financial statements are capable of delivering. While analysts may want to predict the future, others may still wish to understand the past – shareholders will want dividends, governments will want taxation and information for their statistics, and employees will be interested in a fair return for their efforts. In Germany, the protection of creditors has been the driving force behind corporate reporting. Bankers are interested in predicting future cash flows, but as they are generally in a privileged position, having access to the company’s budgets, they will not have to rely on the financial statements to make their predictions. Increasingly, companies are having private meetings with key stakeholders (Holland, 1997; Marston, 1999).

Scott (1994: 62) considered that there ‘is the increasing evidence that investors may not be as rational and security markets may not be as efficient as previously believed. This threatens the foundation upon which most financial accounting research over the last 25 years has been based, and has led to calls for a “return to fundamentals”.’

The debate about financial performance

The ‘statement of financial performance’ (ASB, 2000) combines the statement of total recognized gains and losses and the profit and loss account, one reason for this being that users seemed to be ignoring the ‘statement of total recognized gains and losses’. However, there is a question as to what is meant by the word ‘performance’ and whether just focusing on ‘financial performance’ will really indicate an enterprise’s overall performance. The operating and financial review aims to expand on the contents of the financial statements, but in the management accounting area, the recognition of the limitations of financial performance indicators has resulted in the search for complementary indicators, such as the balanced scorecard (Kaplan and Norton, 1996). These issues are now being recognized in relation to external reporting (Upton, 2001).

Advances in technology

This has resulted in a questioning of the relevance of the financial statements: ‘The demand for more timely and broader information comes from decision makers, such as potential investors, creditors, customers and suppliers, who are doing, or may want to do, business with an entity’ (CICA, 1999: 2). However, because of the multitude of decisions involved, ‘[i]t is likely that decision makers’ information needs will be met at least in part by real-time access to corporate databases, a possibility that is increasingly feasible given advances in information technology’ (CICA, 1999: 2), whereby users would be able to access the data they considered relevant to their decisions.

Technology-driven information systems are capable of capturing, organizing and disseminating information in ‘real time’. Investors can quickly access information and consequently have expanded their demands for both financial and non-financial information. Some of that information is ‘traditional’ historical financial data, and some of it is new. (Panel on Audit Effectiveness, 2000: 172)

It is even suggested that greater disclosure may result in a lower cost of equity capital for some firms (Botosan, 1997). However, if users are ignoring data in the financial statements, one has to wonder how they would cope with this cornucopia of financial data:

Accounting is the instrument used to treat a mass of enterprise facts so that the flow of transactions becomes intelligible. . . . It is hard to overestimate the contribution to understanding made by compressing a mass of facts and by setting up the resulting data in ways that permit comparisons to be made. The mind cannot grasp very many separate facts at once, and figures lose most of their significance unless the eyes can see quickly whether they are larger or smaller than they were. (Lit...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• Acknowledgements
• List of Illustrations
• Preface
• 1 Issues in Financial Reporting
• 2 An Exploration of the Nature of Accounting ‘Theory’
• 3 Developments in Accounting and Corporate Reporting
• 4 Financial Reporting: Frameworks Without Foundations?
• 5 Developments in Auditing and Assurance
• 6 The Management–Auditor Relationship: Auditing Motivations
• 7 Communication Through the Audit Report: What Is the Auditor Trying To Say?
• 8 An Exploration of the Financial Reporting Expectations Gap
• 9 A Reconfiguration of the External Reporting Conceptual Framework Conundrum
• 10 The Elusive Holy Grail
• Name index
• Subject index