Chapter 6 – products of the financial reporting process

Identification of the reporting entity

 ‘a circumscribed area of economic activities whose financial information has the potential to
be useful to existing and potential equity investors, lenders, and other creditors who cannot
directly obtain the information they need in making decision about providing resources to the
entity and in assessing whether management and the governing board of that entity have
made efficient and effective use of the resources provided’ (definition of reporting entity,
covered in chapter 1/2)
 reporting entity is not necessarily the same as a legal entity as the entity could include
multiple legal entities all bound by the concept of control
 a reporting entity may control several legal entities and conduct consolidated financial
statements
 control exists when an investor is exposed, or has rights, to variable returns from its
involvement with an investee and can affect those returns through its power over the
investee

when information is reported

 annual reports were not always done by all companies

 introduction of income tax, separation of ownership from control and monitoring concerns
of shareholders are responsible for the universal adoption of annual accounting cycle
 International accounting standards now require financial reports to be presented at least
annually.
 In many countries, listed companies are required to produce interim financial accounts.
 Real-time reporting opens the possibility of non-standardised reporting periods
 Arguments for standardisation of reporting periods
o It allows investors to compare and evaluate managements of different reporting
entities. (Comparability)
o The requirement for dividends makes it necessary to close the books and calculate
profits to declare a dividend. (Dividends calculation)
o Various company acts require entities to produce annual financial statements.
o Accounts also are a control mechanism, and this requires standardisation of the
reporting period.
 Arguments for a more flexible approach
o The operating cycle of each company is different than the other
o Any standardised period cuts across many uncompleted transactions and therefore
requires arbitrary apportioning (randomly assigning uncompleted transactions
between the two periods)
o Better to focus on natural earnings cycle of business
o Reduce short term earnings management (standardisation puts pressure on
management to produce profits over short term periods)
 Interim reporting
o Reports issued between annual reports
o Not mandatory
o Covered by AASB 134/IAS 34 and must include:
 Condensed balance sheet
 Condensed income statement
  Condensed statement of changes in equity
 Condensed statement of cash flows
 Selected explanatory notes
 Comparative information

Manipulation of reported earnings

 is the use of management’s discretion to make accounting choices or to design transactions

to affect the possibilities of wealth transfer between the company and society (political
costs), funds providers (cost of capital) or managers (compensation plans).
 Legal manipulation (earnings management)
o Income smoothing
o Big bath accounting
o Creative accounting
 Illegal manipulation
o Fraud
 Why management manipulates accounts
o To influence wealth transfers among various stakeholders
o Incentives for earnings management arise when accounting information is used for
performance evaluation
o Managers have the opportunity to act in their own interest
 Why accounts are open to manipulation
o Managers have the advantage of information asymmetry
o Communication with outsiders is limited to financial information provided
o Transactions are combined with manager’s inside information within the accrual
system
o This creates an opportunity for management to decide what to disclose
 Earnings management
o Depends on the timing differences that arise between accrual and cash accounting
o Generally, brings revenues into the year of need and postpone expenses into the
next years
o Creative compliance uses schemes to avoid the law. Lawyers are used to ensure that
these schemes are defensible (costly)
o Management may take predictions about earnings and set them as targets, selecting
investments that will most likely produce the predicted level of earnings
o Bad earnings management – intervening to hide true operating performance by
creating artificial accounting entries or by stretching the estimates required in
preparing financial statements beyond reasonableness
o Good earnings management –
 management acting to try to create stable financial performance by
acceptable, voluntary business decisions
 spotting the most beneficial use for the resources and quickly reacting to
unforeseen circumstances
 income smoothing – management artificially manipulate earnings to
produce a steadily growing profit stream (above-normal profits are reserved
for future times when they are needed)
  big bath accounting – current income is reduced by new management team
to reduce current income so that low income levels are blamed on previous
management team and reduce basis for future comparison
o pro forma reports
 used as “as though” results
 use pro forma financial statements to exclude one-time or unusual items
from earnings
 also known as cash earnings, core earnings, adjusted earnings, or earnings
before certain items
 they are incomplete, inaccurate and misleading
 sometimes used to turn loss under GAAP into profit under pro forma
 not comparable across entities
 usually used by less profitable firms with higher debt levels

Exclusion of activities from the financial reporting process

 accounting regulations may result in inaccurate company assessment because they do not
allow certain items to be reported (e.g. intangible assets)
 to overcome accounting regulations, firms make voluntary disclosures to fill the void
between what can be reported within accounting rules and drivers of value generation
within firms
 disclosures may relate to human resources, environment, community
 intangible assets
o Traditional accounting systems are not able to provide information about corporate
intangible assets.
o Intangibles are identified as the value and growth creators in almost all industries
o Intangibles are seen to be the reason the book value of corporations has been
shrinking in relation to market value
o Intangible assets are defined as identifiable non-monetary assets without physical
substance
o IAS 38 states they should only be recognised when it is probable that future
economic benefits generated will flow into the business and when these benefits
can be reliably measured (must be able to be separated from the reporting entity)
o IAS 38 specifically prohibits the recognition of brands, mastheads, publishing titles,
customer lists and the like that are internally generated because the IASB believed
that they would rarely meet the recognition criteria
o Recognised intangibles are subject to the impairment test only for those with an
active market
 Intellectual capital
o Refers to
 Capital created by employees or purchased, such as patents, computer and
administrative systems, concepts, models, and research and development
 Relationships with customers and suppliers that consist of brand names,
trademarks and the like
 Capital embedded in employees, such as through education, training, values
and experience.
o Only intellectual capital that has been purchased will be recognised in the financial
statements
 o The rate of return to intellectual capital investment can be determined only through
an analysis involving original expenditure data
o More information is better even if it is uncertain
o voluntary disclosure appears to be the answer to the lack of comprehensiveness of
financial statements

Voluntary disclosures

 purpose:
o marketing; to project a corporate image;
o to ‘impression manage’ to ensure top management is portrayed favourably;
o to ‘sell’ an organisation;
o and to influence the perceptions of stakeholders.
o Its dominance as a communication device is shown by the many variations in its
structure, content and presentation.
 Reports communicate through words and visual images comprising
o quantitative information,
o narratives,
o photographs,
o tables and graphs.
 Commonly divided into two sections
o In the rear section
o In a separate volume
 Annual reports provide reporting entities with the opportunity to provide financial
information to users about corporate activities that are not covered in the financial
statements
 Annual reports cover
o governance,
o employee issues such as health and safety,
o ethical, environmental and social issues,
o information relating to intangibles, particularly intellectual capital
 it can be used as a marketing tool and conveyor of a particular organisational image to its
readers
 an advantage is that these disclosures can influence and mould readers’ expectations about
the reporting corporation
 negative images are avoided, results are explained in technical accounting terms or in
convoluted language
 positive performance is explained in strict, simple cause-and-effect terminology
 responsibility and accountability are said to be based on a hedonic bias (blame negative
results on external, environmental causes and take credit for positive results)
 financial graphs allow management to present information in a flexible way
 electronic reporting
o often confusing, unpredictable and difficult to monitor
o risk if losing control of its public image, therefore policies are slow to develop
o both financial and non-financial information is disclosed on websites
o however, there is lack of standardisation
 o users believe that all financial information accessed through the website is audited
(not true), there are no clear lines or differentiation between audited and unaudited
financial information
o IASB developed a code of conduct
 Boundaries of financial reports must be clear
 Content of financial reports must be the same as paper based reports
 Report should be complete, clearly dated and timely
 Information must be user friendly and downloadable
 Information should be appropriately secured to ensure reliability
o Some of these problems are overcome by XBRL (extensible business reporting
language)
 A dictionary of commonly used financial reporting terms
 Reduces costs
 Increase efficiency
 Improved accuracy and reliability
 SEC mandated all public US companies to file their financial statements
using XBRL by 2011

Why entities voluntarily disclose

 Information should be available to groups other than investors because the interactions of a
company are not limited to just shareholders but to other stakeholder groups who also have
a right to be provided with information about how the activities of a company impact them
 Management motivation to disclose
o Accountability (responsibility to disclose information to those with a right to know)
o To legitimise various aspects of their respective organisations
 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 (stakeholder theory)
 To forestall regulations (institutional theory)
 To comply with industry requirements
 To win reporting awards
o Management discloses environmental information 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
 Research into annual reports
o The similarities in the two lists above provide common thread to build theories
o This is called corporate social responsibility/reporting (CSR)
o The most common theories about why management disclose information are
 Accountability theory
  Views corporations as reacting to the concerns of external parties
 Two interpretations to this theory
o Relationship between company and its shareholders
(primary focus on financial information within the annual
reports)
o Relationship between corporation and its stakeholders
(focus may be any disclosures within an annual report)
 Legitimacy theory
 Stakeholder theory