Chapter 6Products of the

Financial Reporting Process

PowerPoint Presentation by Matthew Tilling

©2012 John Wiley & Sons Australia Ltd

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’.

When Information Is Reported

• International accounting standards 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 up the possibility of non-standardised reporting periods.

Arguments for Standardisation ofReporting Periods

1. It allows investors to compare and evaluate managements of different reporting entities.

2. The requirement for dividends makes it necessary to close the books and calculate profits to declare a dividend.

3. Various company acts require entities to produce annual financial statements.

4. Accounts also are a control mechanism and this requires standardisation of the reporting period.

Arguments for a More Flexible Approach to Reporting Periods

• Any standardised period cuts across many uncompleted transactions and therefore requires arbitrary apportioning.

• Better to focus on natural earnings cycle of business.

• Reduce short term earnings management.

Interim Reporting

• Not mandated by IASB• Required by Australian law for some entities• Covered by AASB134 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

Alleged Manipulation OfReported Earnings

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).

• Ongoing and serious concern• Earnings Management• Fraud

Alleged Manipulation OfReported Earnings

• Why does management manipulate the accounts?– to influence wealth transfers among the various

stakeholders. Including• Management, controlling shareholders, other

shareholders and potential shareholders.

• Why are accounts open to manipulation?– Information asymmetry

Earnings Management

• Bottom-line profit is the most widely used indicator of performance.

• Can be earnings managed.– Usually based on the timing differences that arise

between accrual and cash accounting.• Often managed to meet analysts’ forecasts.’• ‘Good’ versus ‘bad’ earnings management.

Income Smoothing

• Management artificially manipulates earnings to produce a steadily growing profit stream.– Above-normal profits are artificially reduced by

certain provisions.• Called ‘taking a bath’.

– These provisions are called upon inflate below- normal profits.

• Allows managers to increase remuneration.• Also can be politically beneficial.

Pro Forma Reports: Massaging Earnings

• Pro forma results are primarily used to show ‘as though’ results. Often used when– The company has not operated for a full year.– There is a significant accounting policy change.– Exclude one-time or unusual items.

• Critics claim they are incomplete, inaccurate and misleading.– Firms are more likely to use them when their share

price and earnings decline in order to meet analysts’ expectations and to downplay bad earnings news.

Exclusion Of Activities From The Financial Reporting Process

• Accounting regulations may result in inaccurate reporting.

• Voluntary disclosure can be used to fill the void between what can be reported within accounting rules and the drivers of value generation within firms.

Intangibles

• Traditional accounting systems are not able to provide good information about corporate intangible assets.

‘As much of two-thirds or three-fourths of the real value of the company is based on intangibles, and investors are not getting the information they need to make decisions’.

• This is seen to be the reason the book value of corporations has been shrinking in relation to market value.

Intangibles

• AASB138/IAS38 specifically prohibits the recognition of brands, mastheads, publishing titles, customer lists and expenditure on research, training, advertising and start-up activities.

• Once recognised revaluations are restricted to those intangibles for which there is an active market.

Intellectual Capital

• Refers to– Capital created by employees or purchased, such as

patents, computer and administrative systems, concepts, models 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.

• Only intellectual capital that has been purchased will be recognised in the financial statements

Intellectual Capital

• Knowledge organisations’ assets are their employees because of the increasing tendency for technology to be embodied in intellectual property and labour.

• The rate of return to intellectual capital investment can be determined only through an analysis involving original expenditure data.

Voluntary Disclosures

• The annual report contains both mandated financial statements and voluntary disclosure.

• Information outside the financial statements is not audited.

• The annual report can be used as a marketing tool as well as a conveyor of a particular organisational image to its readers.

Voluntary Disclosures

• Narrative voluntary disclosures in annual reports used to report activities excluded by accounting standards from the financial statements.

• Impression management used to improve corporate image.

• Can be biased, even misleading.

Electronic Reporting• Using websites, message boards and blogs.• Both financial and non-financial information is disclosed on

reporting entities’ websites.• Only some, or none, of this may be audited.• The IASB has developed a code of conduct for Internet

reporting. – Boundaries of reports should be clear.– Content of should be the same as the paper-based reports.– Reports should be complete, clearly dated and timely.– Information should be user friendly and downloadable.– Information should be secured to ensure reliability.

Electronic reporting

• Extensible Business Reporting Language (XBRL)• XBRL is a language for electronic

communication of financial data.– It standardises presentation.– It makes possible continuous disclosure by

reporting entities.– It offers cost savings.– It improves efficiency, accuracy and reliability.

Why Entities Voluntarily Disclose

• Mandated accounting information is constrained.

• Definition of users is limited.• Organisations require and desire broad

support.• They have multiple responsibilities.• Variety of information is necessary to satisfy

and inform range of stakeholders.

Management Motivation to Disclose

• Deegan lists ten reasons for voluntarily disclosure1. To comply with legal requirements2. Because of economic rationality arguments3. Because of accountability to stakeholders4. Because of borrowing requirements5. To comply with community expectations

Management Motivation to Disclose

• Deegan lists ten reasons for voluntarily disclosure6. To ward off threats to organisational legitimacy7. To manage powerful stakeholders8. To forestall regulations9. To comply with industry requirements10. To win reporting awards

Management Motivation to Disclose

• O’Donovan’s research suggests that management discloses environmental information to:1. Align management’s values with social values2. Pre-empt attacks from pressure groups3. Improve corporate reputations4. Provide opportunities to lead debates5. Secure endorsements6. Demonstrate strong management principles7. Demonstrate social responsibilities

Research into Annual Reports

• Accountability Theory– Views corporations, through their management,

as reacting to the concerns of external parties. – Accountability involves monitoring, evaluation,

and control of organisational agents– Accountability focuses upon the relationship

between the corporation and users of its annual reports.

Research into Annual Reports

• Legitimacy Theory– The annual report is a tool with which

management signals its reactions to the concerns of particular stakeholders.

– Successful legitimation depends on reporting entities convincing society that a congruency of actions and values exists.

• Stakeholder theory– Management stakeholders about entity activities

through means such as the annual report

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