Sample Finance Essay: How and to whom do the financial statements make firms accountable? (Demo)

Introduction

International accounting policies and practices in financial reporting are adopted to create equilibrium within the global context. Public interest theory motivates regulatory bodies such as the International Accounting Standards Board (IASB). Financial reports are important to both shareholders and investors. The main objectives of financial reporting are to “provide information useful to potential investors and creditors for their rational investment and other financial decisions; [and to] provide information on the economic resources of the company” (Bohusova and Nerudova 36). Financial reports have special purposes and target audiences. Financial reports have seven user groups including equity investor group (existing and potential shareholders), loan creditor groups, employee group, analyst-adviser group, business contact group (suppliers, trade creditors, customers and competitors), the government (for tax purposes and regulation), and the general public that might have political and economic interests in knowing how a firm performed (Alexander and Britton 9). Understanding the contents of financial reports also varies among these different groups. Despite the differences among different users, their economic decisions are similar (Young 590). Hence, financial statements serve the information needs of various groups (Young 579).

To create financial reports, some standards must be met. International accounting standards (IAS) are established to “develop, in the public interest, a single set of high quality, understandable and enforceable global accounting standards that require transparent and comparable information in general purpose financial statements” (Barth, Landsman, and Lang 1). An international accounting standard enables investors to examine companies in different countries from a similar perspective. In today’s highly integrated global market, standardization facilitates and maximizes costs. International accounting standards encourage transparency and ensure relevant information is accessible to anyone who needs it (Das, Shil, and Pramanil 194). As a result, the transaction cost of conducting business in any part of the globe is reduced (194).

Accounting quality significantly improved the performance of firms that comply with IAS. Barth, Landsman, and Lang found that firms that applied IAS “show less evidence of earnings smoothing, less evidence of managing earnings towards a target, more timely recognition of losses, and a higher association of accounting amounts with share prices and returns” (31). A more recent study by the same authors documented how the use of the International Financial Reporting Standards (IFRS) improved accounting quality and reduced the cost of capital. They compared firms that complied and firms that refused to comply with IFRS standards (Barth, Landsman, and Lang “International Accounting Standards and Accounting Quality”476).

The accessibility and correctness of financial reports are necessary for investors to enable them to discern the performance of the company and decide whether to invest in them. In recent years, many average citizens and “novice” market players participated in the capital markets. They also contributed to the current economic global storm that has crippled many markets. If financial reports were written to consider the limitations of such participants, the lack of appropriate knowledge to make right decisions in investing might not be one of the reasons why many lost their money in the markets (Ewer 22).

Theoretical Underpinnings of Financial Reporting Accountability

Stakeholder Theory

Stakeholder theory involves a broader range of other stakeholders such as employees, customers, suppliers, bondholders, and the community, among others (Feizizadeh 3353). Stakeholder theory is managerial because it guides the manager on how to conduct and manage business rather than addressing management and economic theorists. Stakeholder theory has two core questions: what is the purpose of the firm and what is its responsibility to its stakeholders (Freeman, Wicks, and Farmar 364).

From the stakeholder theory perspective, Mudrack identified several personality factors that are linked to the perception of rightness in corporate reporting and corporate social responsibility (33). Empirical findings revealed that management supporting the Milton Friedman (1970) view of shareholder primacy tends to tweak acceptable ethical standards to promote maximization of shareholder wealth (qtd in Mudrack 38). Individuals sharing Friedman’s traditional view adopt a Machiavellian attitude and are quite “cynical” about others’ motives (38). Social traditionalists (Mudrack 41–42) correlated positively with Machiavellianism (r = 0.45, p < 0.001) in a survey conducted in one of the Fortune 500 corporations (41–42). This finding is consistent with Friedman, as respondents had no qualms violating ethical standards as long as the action benefits the organization (42).

The inclusion of information that assesses the management’s stewardship is likewise essential to assist primary users to make critical decisions to enhance or protect their investments. The New Zealand Securities Commission pointed out that the inclusion of information on stewardship is essential because “[t]he performance of an entity is intertwined with the performance of management and with management’s stewardship of the entity’s resources” (4). Financial reports should also reflect how management intends to perform its responsibilities to users of the financial report by providing accurate and appropriate information useful in making economic decisions (New Zealand Securities Commission 4).

The inclusion of non-financial information that is also useful for stakeholder decision-making is also necessary. For example, Petty, Ricceri, and Guthrie noted how accounting professionals tend to incorporate intellectual capital in the firm’s valuation to support their decision-making (434). In traditional financial reporting, non-financial aspects such as “staff competencies, customer relationships and computer and administrative systems” did not receive ample attention despite them having a substantial influence on the ability of the firm to create value for its shareholders (435). The study also revealed that intellectual capital reporting is vital to encourage companies to be more transparent about their activities. Moreover, the study respondents also suggested that firms that disclose intellectual capital information should be rewarded with higher share prices (443).

The inclusion of non-financial information in financial reporting may be viewed by some as cumbersome and an additional expense for the company. However, the qualitative value of the company based on non-financial information may provide credible evidence that the firm can maximize shareholder value. Non-financial information is difficult to quantify. Nonetheless, voluntary disclosures of non-financial information should be present in financial reports. Incorporating stewardship information in the financial report is vital because the report is the best communication medium through which the company interacts with its shareholders and others that might be interested in the activities and performance of the company (Lennard 13). This view suggested that any information previously released or with the management’s willingness to release to the public should eventually be reflected in the financial reports (13). It is also insufficient to state that non-financial information such as stewardship information is purely for “providing a check on the integrity, efficiency or capability of management: it is a necessary response to the development of the modern company and a fundamental building block of corporate governance” (Lennard 14).

Agency Theory

Compared with stakeholder theory, agency theory proposed a traditional view regarding the accountability of corporations. In agency theory, the corporation is solely responsible to its shareholders and the company must strive to maximize profits to benefit shareholders (Mudrack 38; Feizizadeh 1). The board of directors ensures that stakeholders benefit the most from the company’s business activities.

Agency theory is the cornerstone of corporate governance because of its impact, policy, and practice. The prescription for the appropriate code of corporate governance, director training, and board procedures is influenced by agency theory (Lan and Heracleous, 2010). Lan and Heracleous presented an alternative view regarding the principal-agent relationship in agency theory. In their view, the principal is not the shareholder, but the corporation. In classical agency theory, the first-order agent is the shareholders, and the board is subservient to them. However, Lan and Heracleous argued that “the board is not an agent but an autonomous fiduciary – someone who is entrusted with the power to act on behalf of and the benefit of a beneficiary” (295).

Moreover, the classical agency theory contended that the main role of the board is to monitor the managers and sure that their interests would not diverge substantially from the interests of the shareholder. Lan and Heracleous viewed this relationship differently because they argued that boards should mediate rather than monitor the interests of managers. The board is someone who balances competing claims and interests. Classical agency theory assumes that the agent will always pursue the interests of the principal may not be true because of various incidences that agents exhibited deviant behavior (i.e., falsely reporting company earnings). Managers or agents would at some point, pursue personal interests, particularly if their pay is tied to maximizing profit. From another perspective, Bryer suggested that the corporation is the principle that compels its agents, in this case, the managers or employees of the company, and judges their performances and requiring agents to report and explain performance (557). Hence, accounts are the means by which the principal controls its agents in two ways, namely, to account, calculate, or provide a narrative to explain results and to hold the agent accountable for the state of affairs of the company (557).

Jensen and Meckling argued that “the agent as someone who by his relationship to the principal has been delegated authority to act on behalf of the principal” (qtd in Donaldson 263). However, the actions of the agent may not always conform to the interests of the principal. Essentially, the agency theory relies on explicit normative terms, such as property rights and authority. In general, agency theorists presume that “principals have a justified claim or entitlement to their property and that agents are justified – have authority – to act on behalf of the best interests of their principals” (263).

The perspective on agency theory on capital structure focuses on the impact of debt on reducing conflicts. The theory presents an alternative strategy to mitigate agency conflict that arises from divergent interests between shareholders and managers by introducing an alternative governance structure (Kochhar 715). Agency theory also views debt as a principal instrument to reduce conflict because the “creation of debt reduces the agency costs of free cash flow by reducing the amount available to managers” (715). The curtailment of debt serves as a risk mitigation strategy that prevents managers from spending free cash in a haphazard and wasteful manner. Agency theory also holds managers accountable for poor debt decisions that shareholders could sue the firm in bankruptcy court and claim its assets.

Moreover, the principle is a deterrent for managers undertaking poor decisions on debt, as well as how the money of the firm is spent. The managers lose the privilege to make decisions on behalf of the company, as well as lose employment. The ultimate goal is to enable managers to use assets efficiently to increase firm value (Kochhar 715).

Financial reports are communication media that companies use to interact with their stakeholders. Convergence must exist between how the company conceptualizes its identity (who/what we are) and how it communicates (what we say we are) with the public (Fukukawa, Balmer, and Gray 1). Stakeholder and customers’ perceptions and perspectives must also be part of the company’s identity management. They are relevant because they provide guidance on what or how the organization should behave (1). Accurate and factual financial reports reflect the values that are important to the company. The relationship between the company and its stakeholders has evolved from one that strictly followed the traditional principal-agent into something broader to include the general public. Information asymmetry does exist between the reported and actual performance of the company. Companies must commit to reduce or eliminate this asymmetry because the information provided in financial reports are used in critical investment decisions of various stakeholders.

Other Accounting Representations that Promote Accountability

Defining Fair Value

IASB defined fair value as“[t]he amount for which an asset or liability could be exchanged between knowledgeable, willing parties in an arm’s length (Miller and Bahnson 31). Certain attributes concerning a specific asset or liability should be considered when fair value is measured. To measure the fair value of an asset or liability, the prevailing market price, which is deemed most advantageous, should be the price considered. Exit or entry price of assets or liabilities should also be valued as per transaction period (FASB 2008). Both IFRS and US GAAP require the disclosure of fair value for all instruments. In principle, fair value accounting of financial instruments is also identical. For example, IAS 39 and SFAS 115, 133 “require trading securities and derivatives held for trading or as part of a fair value hedge to be measured at fair value with revaluation gains and losses taken directly to income” (Hitz 331). In both regimes, securities are recognized as “as held-to-maturity, non-securitized financial assets, and obligations” (331) except derivatives, which are accounted at cost. IASB requires revaluation model applicable to accounting for property, plant, and equipment (IAS 16) and actively traded intangibles (IAS 38). IASB also “requires full fair value measurement, with remeasurement gains beyond historical cost taken to revaluation surplus (other comprehensive” (Hitz 328). According to Hitz, IASB “adopts fair value measurement in a more consequent manner, accepting the erosion of the twin pillars of the historical cost model, cost-based measurement, and transaction-based income recognition” (328).

IASB developed IFRS 13 1) to reduce complexity and improve consistency in applying fair value measurement principles by implementing a uniform set of requirements for all fair value measurements, 2) to clarify the definition of fair value and provide clearer measurement objective, 3) to improve transparency, and 4) to increase convergence between IFRS and US GAAP (“Fair Value Measurement”). IASB revised and enhanced disclosures related to fair value measurement. This move aims to help the public understand the fair value measurement process and how the measurement affects profit and loss (Ernst and Young). In particular, IFRS 13 resolves the gap by providing appropriate definitions and prescriptions on the proper fair value measurement techniques (Ernst and Young).

Fair value accounting, according to KPMG Partner Theresa Ahlstrom “provides users of financial statements with a clearer picture of the current economic state of a company, making a company’s financial statements more useful or ‘relevant’ in the marketplace”(Casabona qtd in Casabona and Shoaf 20). Mary Barth likewise reflects the same position of the IASB, saying that “[f]air values are relevant because they reflect present economic conditions, i.e., the conditions under which the users will make their decisions” (Barth qtd in Casabona and Shoaf 20).

Presenting Assets

How companies account for their assets (property, plant, and equipment) has a considerable impact on how users of financial reports analyze the company. The inclusion of assets in financial report informs users how the company invests in its property, plant, equipment, and the changes the come with them. Accounting for these require three considerations, namely, “the recognition of the assets, the determination of their carrying amounts and the depreciation charges and impairment losses to be recognized about them” (IAS “IAS 16 – Property, Plant and Equipment” 860).

In valuing tangible asset, the cost should be measurable, and the cost of such items should be the cash price equivalent on the date the asset is recognized (p.865). If it involves deferred payment beyond the normal credit period, the cash price equivalent and the total payment is recognized as interest unless such is considered in the carrying amount as prescribed in IAS 23 (p.865). In IAS 16, accumulated devaluation and accumulated impairment costs of property, plant, and equipment are also considered. This valuation provides a clearer picture of the market value of the property, plant, and equipment. This approach is also consistent with prevailing property valuation practices wherein “the estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arms-length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently and without compulsion” (Hendriks 456). Hendriks also noted that in financial reporting, one should take the valuation of property as a whole because it is better to assess the value of the property if land and physical improvements were taken together (468).

Mansfield and Lawrence pointed out the essentials of having a standard valuation regime on properties, as more companies invest in property, plant, and equipment in their home countries as well as offshore. The full interpretation of the financial reports of businesses is only achievable if interpreting the financial statements is made by financial and cultural environment of the location where the company operates (290).

Regarding leases, IAS 17 classifies leases according to the “the extent to which risks and rewards incidental to ownership of a leased asset lie with the lessor or the lessee” (IAS “IAS 17 – Leases” 895). The standard lists the following as risks: “possibilities of losses from idle capacity or technological obsolescence and of variations in return because of changing economic conditions,” whereas rewards are “the expectation of profitable operation over the asset’s economic life and of gain from appreciation in value or realisation of a residual value” (895). When a lease does not transfer substantial risks or rewards, it is considered as the operating lease (895).

A company or entity must also account for borrowed funds if it intends to use it to capitalize the business. A qualifying account should be “an asset that necessarily takes a substantial period to get ready for its intended use or sale” (IAS “IAS 23 – Borrowing Costs.” 1098). Qualifying assets could be “inventories, plant and equipment, intangibles and investment properties” (Epstein and Jermakowicz 80). The company or entity must calculate “the number of borrowing costs eligible for capitalization as the actual borrowing costs incurred on that borrowing during the period less any investment income on the temporary investment of those borrowings” (IAS “IAS 23 – Borrowing Costs.” 1100).

Costing

Considering the changing prices, continuously contemporary accounting is more suitable for the current market condition. Traditional accounting systems are unsuitable because of the dynamics of a business environment that is in constant flux. Traditional management control systems such as budgetary control, pricing, and make or buy decision are no longer relevant (Gupta and Gunasekaran 339). Historical cost accounting system assumes that the value of currency remains static and this is unrealistic in these times.

Riahi-Belkaoui characterized historical accounting as 1) the use of historical cost as the attribute of the elements of financial statements, 2) the assumption of the stable monetary unit, 3) the matching principle, and 4) the realization principle (28). Historical cost accounting is advantageous because it is interpretable and it is based on “the concept of money maintenance” (31). However, historical costs financial statements may not be relevant because the command of goals (COG) is not measured. COG is important because it reflects the changes in specific and general price levels (31). Consequently, it represents the capacity of the firm to buy the number of goods necessary to maintain capital (31).

Moreover, historical costs contain timing errors because the accounting figure includes operating income and holding gains and losses from the current and the past periods. It also omits operating income profit, holding gains and losses obtained in the current period but are recognizable in the future. Finally, historical contains measurement-unit errors because it does not consider general price changes and specific price changes because it relies on historical cost (30).

By contrast, continuously contemporary accounting (CoCoA) as proposed by Chambers (1966), used realizable market value or seller’s price as a valuation basis (Liang 223+). In CoCoA, the current resale price is continually recorded as price movements occur. Hussey (93) referred to CoCoA as “method of accounting that defines a company’s financial position as the ability of that enterprise to adapt to a changing environment; it permits the recognition of general price level changes.” Under the continuously contemporary accounting, the assets are adjusted to net realizable value (NRV), and depreciation is obtained in the fall of NRV of an asset over a period. The system is useful because it provides the management with useful information and allows it to make decisions concerning the future use of assets (Nobes 173). Chamber also proposed that assets be valued at the price it could be liquidated in the current market. The saleability of the asset “becomes a test for their valuation in the balance sheet” (Holmes125). It generally leaves the assets up for market appraisal at current prices. The system avoids “the subjectiveness of the doctrine of conservatism” (126).

Conclusion

In general, financial reports should reflect transparency and accuracy to enable users to make the correct investment decisions. Representations in financial statements should generally encourage companies to provide correct and accurate information to its stakeholders and the general public. Information asymmetry does exist, and companies must strive to eliminate such inconsistencies in their reports because investors use financial statements in critical investment decision making.

Works Cited

Alexander, David and Anne Britton. Financial Reporting 7th ed. Cengage Learning EMEA, 2004.

Riahi-Belkaoui, A. Earnings measurement, determination, management, and usefulness: an empirical approach. Westport, CT: Quorum Books, 1999.

Barth, M.E., W.R. Landsman, and M.H. Lang. “International Accounting Standards and Accounting Quality.” Journal of Accounting Research 46.3(2008): 467–498.

Barth, M.E., W.R. Landsman, and M.H. Lang. “International Accounting Standards and Accounting Quality.” Working Paper, Stanford University Graduate School of Business, California, 2006.

Bohusova, H. and D. Nerudova. “IFRS and US GAAP Convergence in the Area of Borrowing Costs.” International Journal of Business Research 9.6(2009): 34–45.

Bryer, Rob. “Accounting and control of the labour process.” Critical Perspectives on Accounting 17 (2006): 551–598.

Casabona, P. and V. Shoaf. “Fair Value Accounting and the Credit Crisis.” Review of Business 30.2(2010):19–30.

Das, B., N. Shil, and A. Pramanil. “Harmonization of Accounting Standards Through Internationalization.” International Business Research 2.2(2009): 194–201.

Donaldson, T. “The epistemic fault line in corporate governance.” Academy of Management Review 37.2(2012): 256–271.

Epstein, B.J. and E. Jermakowicz, E. “Interest Capitalization: One Small Step Toward Convergence.” Journal of Accountancy 205.5(2008): 80.

Ernst and Young. “Fair Value Measurement Guidance Converges.” 2011. Web. 21 May 2016 http://www.ey.com/Publication/vwLUAssets/IFRS_Developments_Issue_2/$File/IFRS_Developments_Issue_2_GL_IFRS.pdf

Ewer, Sid R. “Transparency and Understandability, But for Whom?” The CPA Journal 77.2(2007): 16–22.

FASB. “Statement of Financial Accounting Standards No. 157 Fair Value Measurements.” 2008. Web. 21 May 2016 <http://www.fasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175820931833&blobheader=application%2Fpdf>

“Fair Value Measurement.” 2011. Web. 21 May 2016 <http://www.ifrs.org/Current+Projects/IASB+Projects/Fair+Value+Measurement/Fair+Value+Measurement.htm>

Feizizadeh, A. “Corporate governance: Frameworks.” Indian Journal of Science & Technology 5.9(2012): 3353–3361.

Freeman, R.E, Wicks, A.C. and Parmar, B. 2004, ‘Stakeholder Theory and “The Corporate Objective Revisited”’, Organization Science, vol. 15, no.3, pp. 364-369.

Hendriks, D. “Apportionment in property valuation: should we separate the inseparable?” Journal of Property Investment & Finance 23.5 (2005): 455–470.

Hepp, J. “Revising the Conceptual Framework for Principles-based Accounting: An Institutional Economic Approach to the Elements and Objectives of Accounting.” 2005. Web. 21 May 2016 <http://aux.zicklin.baruch.cuny.edu/cpa2005/papers.htm/8301hepp.htm>

Hitz, J-M. “The Decision Usefulness of Fair Value Accounting – A Theoretical Perspective.” European Accounting Review 16.2(2007): 323–362.

Holmes, K. The concept of income: A multidisciplinary analysis. Amsterdam, The Netherlands: IBFD Publications, 2001.

Hussey, R. (ed). A dictionary of accounting. Oxford: Oxford University Press, 1999.

Liang, P.J. “Recognition: An information content perspective.” Accounting Horizons 15.3(2011): 223+. Web. 21 May 2106 Questia Online Library database.

Mansfield, J.R. and L. Lawrence. “Shaping the Future: The Impacts of Evolving International Accounting Standards on Valuation Practice in the UK and Germany.” Property Management 22.4(2004): 289–303.

Miller, P.B.W. and P.R. Bahnson. “Refining Fair Value Measurement.” Journal of Accountancy 204.5(2007): 30–36.

New Zealand Securities Commission. “IASB Exposure Draft An Improved Conceptual Framework for Financial Reporting: Objective and Qualitative Characteristics.” 2008. Web. 21 May 2016 <http://www.iasb.org/NR/rdonlyres/2E51D224-4AF4-4A95-972D-4648F2CA744C/7447/20080908000922_SecuritiesCommissionNZsubmissiontoEDObjectiveandCharacteristics.pdf>

Petty, R., F. Ricceri, and J. Guthrie. “Intellectual Capital: A User’s Perspective.” Management Research News 31.6(2008): 434–447.

Young, Joni J. “Making up Users.” Accounting, Organizations and Society 31 (2006): 579–600.

Related Posts

Leave a comment