Chapter 6: Products of the financial reporting process Contemporary issue 6.1 Corporate accounting systems are out of date Questions Why do financial statements prepared under the IASB’s Conceptual Framework and standards fail to meet the objective of financial reporting as outlined in the Conceptual Framework? Why do you think the author of the extract would expect readers of a marketing journal would be interested in financial reporting? What difficulties do you see in requiring the disclosed information to be ‘reliable and comparable’ and ‘future oriented’? 1. Financial statements are unable to achieve the objective of financial reporting because firms do not report information that explains the main trends and factors that underlie their development, performance, and position. Examples of such information include details about the nature of the business, key resources, risks and relationships, and performance measures and indicators. 2. Marketing focuses on the consumer and getting a “better deal” for them. Uses of financial statements are consumers of the information; closing the gap in what is reported is a step in getting a “better deal” for users. Additionally, the information that Management Commentary should disclose specifically mentions customer measures (derived by marketers) as crucial for assessing operating performance and, therefore, key information that should be reported to investors. 3. Metrics about customer measures derived by marketing and other metrics related to key resource would be reliable and comparable in the accounting sense. Other measures are more subjective. Contemporary issue 6.2 Standardised business language cuts operating jargon confusion Questions What is XBRL? What are the advantages of XBRL as outlined in the extract? Why will companies such as Edgar Online Inc. have to change their focus if they are to survive widespread adoption of XBRL? 1. Extensible business reporting language, or XBRL, is a computer-based language that converts business and financial data to a standardised form. 2. The advantages are: consistency transparency financial data easily accessible and interchangeable. 3. Companies such as Edgar Online Inc. Provide normalised data to analysts but XBRL is able to do this without spending large amounts of expensive time converting data into a searchable and analysable form. Their focus is likely to change to ways to make XBRL data more marketable. Review questions 6.1 Why does accounting have regular reporting periods? Aids comparability and analysis Conventional Check on arithmetical accuracy Report to absentee owners Legal requirement 6.2 Consider the arguments for and against standardised reporting periods. Do you agree that accounting periods should be more flexible? Give reasons for your answer. There are several arguments given to support a more flexible approach to reporting periods. For example, any standardised period cuts across many uncompleted transactions. Standardisation may result in accountants apportioning unfinished operations and allocating assets to an arbitrary accounting period of 12 months. Chambers (cited by Luther) argued that the appropriate accounting period is determined by the nature of the entity, so that it should reflect the earnings cycle of the reporting entity. This view was supported by the American Institute of Certified Public Accountants in 1973 but has not been adopted. Johnson & Kaplan argue that standardisation puts pressure on managers to produce profits over short-term periods. Luther quotes several authors who argue that to overcome the problems created by standardisation, annual accounts should have a cumulative component because they are tentative and conjectural statements, the truth of which cannot be verified until the reporting entity has run its entire course. 6.3 What are the perceived purposes of an annual report? Accountability of managers to absentee owners Provides information for decision making by non-management stakeholders Means of reporting corporate achievements Means of impression management, especially of positive images 6.4 Why are financial statements ‘highly valued’? They are ‘highly valued’ because financial statements have been attested to by a third party (auditor) who is supposedly independent of management. 6.5 What do you understand by the term ‘fair presentation’? Give an example to support your answer. To understand the term ‘fair presentation’ see chapter 2. The term means that the representation should be free from bias. In this light it can be equated with “faithful representation” where the financial statements correspond to the actual events and transaction that are being reported. 6.6 Financial reports have been criticised for their lack of completeness. In what ways do financial reports fail the completeness test? Financial reports report on only those activities sanctioned by GAAP (including IASs). Reporting entities engage in activities that are not captured in the reporting process. For example, social and environmental activities largely go unreported in financial reports. Reporting of Intangibles is restricted by accounting standards so that many intangibles are not included in financial statements. 6.7 Defend the stand taken by accounting authorities in AASB138/IAS38 Intangible Assets in relation to the treatment of intangible assets. The stand by accounting authorities is based on three grounds: probability of the future benefits flowing to the reporting entity is too low lack of reliable measurement for intangibles the inability to separate many intangibles from their controlling entity. 6.8 Define ‘earnings management’. Do you consider it to be good or bad? Why? Earnings management is defined as a ‘manager’s use of accounting discretion through accounting policy choices to portray a desired level of earnings in a particular reporting period’. Whether it is considered good or bad will depend on the acceptance of the arguments of Macintosh et al. 2000 or those of Parfet, 2000. Because the measure of corporate success has become whether a corporation has reached its earnings predictions, the temptation for management is to ‘manage’ earnings to match analysts’ forecasts. In this process, as outlined by Macintosh et al., accounting earnings do not reflect the outcomes of an enterprise’s strategic decisions. Instead, analysts’ predicted earnings determine the strategy of an enterprise to satisfy the prediction. This means management may take predictions about earnings as targets and select investments that are likely to produce reported income equal to or exceeding the analysts’ forecasts. Meanwhile, the market incorporates analysts’ earnings forecasts into share prices. In this way, share prices, analysts’ forecasts and reported income all relate to each other but not to ‘true’ or underlying income. Parfet, a representative of preparers of financial reports, defends earnings management by differentiating ‘bad’ from ‘good’ earnings management. The bad involves intervening to hide true operating performance by creating artificial accounting entries or by stretching the estimates required in preparing financial statements beyond reasonableness. This, he points out, is the realm of hidden reserves, improper revenue (income) recognition and overly aggressive or conservative accounting judgements. Good earnings management, on the other hand, involves management taking actions to try to create stable financial performance by acceptable, voluntary business decisions in the context of competition and market developments. The market tends to reward corporations that achieve stable trends of growing income. Good earnings management involves spotting the most beneficial use for the corporation’s resources and quickly reacting to unforeseen circumstances. Parfet declares earnings management not to be a bad thing but a reflection of expectations and demands, both inside and outside a business, on the part of all stakeholders in the capital market. 6.9 Why are annual reports so well regarded? Chief means of communication between management and non-management stakeholders Contain the audited financial statements The audited statements give credibility to the annual report. Annual reports also contain information not recognised in the financial statements, information which is often complementary to the financials. Annual reports are the main source of voluntary disclosures by management. 6.10 Researchers speculate that management is motivated to disclose information voluntarily either because it feels accountable or because it wishes to legitimise its activities. Which do you think is the more likely reason and why? “Accountable” invokes a responsibility or liability to be called to account whereas legitimacy implies being in accordance with the values of society. The argument should be based on who or what can call management to account and whether they would so. In relation to legitimacy, scholars argue that an organisation’s survival will be threatened if society perceives that it has breached its social contract in which societal values are embedded. Management will be “called to account" societal concerns. 6.11 Debate whether management should solely pursue profits. The pursuit of profit is normally the concern of shareholders to whom management is accountable in a broad sense. However, the sole pursuit of profits may cause harm such as in the case of James Hardie. In that situation, the changes by management to their liability to those harmed by asbestos potentially created great harm. Profits were being pursued to the detriment of those harmed by the company’s product. A notable case was the Ford Pinto (USA) where even minor accidents ignited the car causing serious injury to those travelling in the car. Ford has pursued profits rather than acknowledging a duty of care to those who bought the vehicle. 6.12 What factors appear to instigate voluntary disclosure by management in annual reports? Accounting standards prevent the recognition of many assets that contribute to the market value of the reporting entity — voluntary disclosures make this information available. To improve corporate reputations Concern for stakeholders — a concern wider than that for shareholders The philosophy that an entity has responsibilities beyond its legal responsibilities. Accountability To legitimise various aspects of a reporting entity To comply with community expectations, legal requirements and industry requirements Borrowing requirements require such disclosures To forestall regulations or actions by pressure groups To win reporting awards and/or to secure endorsements 6.13 Why should management explain poor performance in technical accounting terms? Investors and other information users are assumed to be non-sophisticated users who are unlikely to understand technical accounting terms and so, can be misled in relation to the so-called factors leading to a poor performance. The aim is to assign responsibility for the poor performance to factors other than those in the control of management. In contrast, good performances are reported in clear non-accounting terms, with responsibility for the performance given to management. 6.14 Why do you think environmental disclosures are more researched than other social disclosures? Answers can be based on the reasons for disclosures: Deegan lists ten reasons management might voluntarily disclose information in annual reports: to comply with legal requirements because of economic rationality arguments because of management’s feeling that it is accountable to stakeholders because of borrowing requirements to comply with community expectations to ward off threats to organisational legitimacy to manage powerful stakeholders to forestall regulations to comply with industry requirements to win reporting awards. O’Donovan’s research suggests that management discloses environmental information in annual reports to: align management’s values with social values pre-empt attacks from pressure groups improve corporate reputations provide opportunities to lead debates secure endorsements demonstrate strong management principles demonstrate social responsibilities 6.15 Why is XBRL a ‘language’? Language can be thought of as the communication of data, ideas, thoughts and feelings through a system of arbitrary signals, such as voice sounds, gestures, or written symbols. As a language, XBRL creates data is created by ‘tagging’ financial information. The XBRL tagging process converts the financial information contained within a document such as an excel spreadsheet into a ‘document’ or computer file with XBRL codes. 6.16 Debate whether XBRL is the likely future of financial reporting. XBRL fulfils many of the desired conditions of financial reporting such as timeliness and comparability as well as satisfying the reliance on electronics as a means of communication. Application questions 6.17 (a-j) Answers will depend on the annual report chosen and its financial year. Students should be encouraged to select an annual report from a non-listed entity so that comparisons can be made with a listed company’s annual report (case study 6.1). Most answers can be supplied in tabular form. Case study questions Case study 6.1 Reading the annual report: ten issues to consider Questions Obtain a copy of an annual report issued by a listed company. Follow the suggestions of the corporate regulator, and analyse the annual report: (a) Examine the figures in the financial statements to get an overall impression of the financial performance of the company. (b) Note which figures you think are important to an understanding of the financial performance of the company you have chosen. (c) Read what management has to say about these figures in the front half of the report. (d) Return to the financial report and examine the figures again, taking into account what management has said in the front half. Has your assessment changed in any way? How? Write a short assessment of the company as a potential investment. 1. Annual reports and subsequent answers will depend on the annual report chosen by the student and its financial year. 2. (a) Calculation of the commonly used financial ratios would be helpful in answering this question. (b) The calculated ratios especially those relating to liquidity, profitability, debt, cash flows and operating performance should be helpful. (c) Care should be taken to align the numbers reported in the financial statements and those reported in the front half of the annual report. Management discussion can enlighten the reported numbers; it can also obfuscate them. Impression management has been identified as a tool used in annual reports. Positive images will be promoted; negative images will be avoided. This strategy has been shown to be applied to the figures reported in the front half, especially where those figures are reported graphically. Students should be aware that the figures may reflect earnings management and realise that earnings management is difficult to detect from a public document such as the annual report. (d) Students should be guided by the questions identified by ASIC especially those relating to the year’s highlights and the comparison with the previous annual report if it is available. 3. The assessment should include the key areas identified by the regulator: operational and strategic activities of the company, the financial results and the future strategic directions and performance. The 10 questions identified in the case study should give the assessment its structure. Case study 6.2 The impact of the global financial crisis on IAS 39 Financial Instruments: Recognition and Measurement Questions Suppose you are a company holding large quantities of financial instruments the market value of which had declined markedly since purchase. How would you classify those instruments and why? Compared to the pre-change IAS39, what are the likely impacts of the changes to IAS 39 on balance sheet values of companies holding large amounts of financial instruments? Will companies with large holdings of dodgy financial instruments be motivated to disclose information about those instruments? Give reasons for your answer. What types of companies are likely to be impacted greatly by the changes to IAS39? How would the changes impact the truthfulness of financial reporting? How do the changes impact on the comparability of financial statements? Would you expect the ‘market’ to look through the changes? How can you empirically verify your answer? Argue whether the changes to IAS 39 represent a form of sanctioned earnings management. 1. The changes to IAS 39 created incentives for those holders of large quantities of financial instruments with large impairment charges to classify the financial instruments as assets “held to maturity” or as “loans and receivables”. 2. Impairment charges that should have been taken to the profit and loss statement will not go there so that reported profitability is higher for those companies with large quantities of financial instruments with declining market values will be higher than if the standard had not been changed. 3. Companies with dodgy financial instruments are likely to take advantage of the information asymmetry between themselves and external stakeholders to manipulate the financial performance of the company by not making any voluntary disclosures about their holdings. Studies of impression management show that annual reports and other corporate communication media with shareholders and other stakeholders generally seek images that have positive expected values, while negatives are avoided. 4. Banks, merchant banks, investment companies, superannuation companies and such. 5. Depends on whether faithful representation is equivalent to truthfulness. The changes impact on the underlying substance of the financial reporting. 6. The four choices should impact negatively on comparability, both of the balance sheet and the profit and loss statements. 7. Advocates of the EMH would argue that the market would be expected to see through the changes. To empirically support an answer, some research into the changes in share prices of companies with financial statements that employed the changes should verify whether the market looked through the changes. Students should be aware that other factors can complicate the results. 8. Earnings management is defined as a ‘manager’s use of accounting discretion through accounting policy choices to portray a desired level of earnings in a particular reporting period’. Solution Manual for Contemporary Issues in Accounting Michaela Rankin, Kimberly Ferlauto, Susan McGowan, Patricia McGowan 9780730343530
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