Issues in Financial Reporting

1
Issues in Financial Reporting

• Corporate Financial Reporting
• Notes taken from Preface and Issues in Financial
  Reporting in Corporate Financial Reporting by
  Andrew Higson,
• published Sage 2005

2
Headings

• Overall
• Theory of accounting
• Motivations of management
• External auditing
• Driving forces behind developments in
  financial reporting
• Conceptual framework (accounting theory)

3
Overall

• Business environment is dynamic.
• The driving forces are
• - globalisation
• - extreme market pressures
• - advances in technology
• - knowledge economy
• - fraud
• - influence of management

4
Overall

• Other driving forces are
• - perspective on information in F.Ss
• - debate about financial performance
• - corporate governance
• - independence
• - real time reporting
• - audit developments
• - assurance services

5
Overall

• . . . leading to a revolution in accounting data
• - in the need for . . .
• -gt financial reporting
• - (and) in the way it is usedd

6
Theory of accounting

• - The conceptual issues behind financial
  reporting.
• - There is no one generally agreed theory
  of accounting.
• - The underlying accounting theory is vague and
  ill-defined.
• - the objective of financial statements has been
  specified vaguely (see below).
• - Conceptual frameworks have been devised (MP).
• - (but), to achieve consensus, there has been
• - compromises by the accounting standard setting
  bodies.

7
Theory of accounting

• The focus is on the myriad of accounting users
• - The standard setting bodies have gone for
  decision- usefulness of financial statements
  (to users).
• - Auditors do not support this.
• - Company Law Review and Caparo judgemet (in
  law) also rejects this
• Should be focussing on
• - the reporting entity
• - communication of its performance and risk
• Question is
• - How to judge an entitys performance and risk?

8
Theory of accounting

• There may be an accounting (financial reporting)
  expectations gap, comprising
• - an audit expectations gap
• - an financial statements expectations gap

9
Theory of accounting

• - There has been conceptual framework projects
• undertaken by the accounting standard setting
  bodies
• - Are these conceptual frameworks really
  conceptual?
• - Is one generally agreed theory of accounting
  at all possible?

10
Motivations of management

• We need to understand
• - the motivations of management and
• - the work of the external auditors
• to understand financial reporting.
• Therefore, to understand figures in financial
  statements,
• it is important to understand managements
  motivations.
• The external audit needs to be seen in terms of
• an audit of managements motivations.

11
Motivations of management

• The final figures in the financial statements may
  be
• - the result of negotiations between management
  and their auditors.
• Auditors therefore should examine
• - the reasonableness of managements
  justification for their arguments.

12
Motivations of management

• Focus (instead) by standard setters on accounting
  users
• The standard setting bodies have gone for
• - decision-usefulness of financial statements
• (to users).
• - Auditors do not support this.
• - Company Law Review and Caparo judgemet (in
  law) also rejects this.

13
Motivations of management

• Should be focussing on
• - the reporting entity
• - communication of its performance and risk
• Question is
• - How to judge an entitys performance and risk?
• - May be an accounting (financial reporting)
  expectations gap, comprising
• - audit expectations gap
• - financial statements expectations gap

14
External auditing

• Financial Reporting and external auditing
• are inextricably linked,
• - as shown by recent financial scandals.
• Inter-relationship between external auditing
• - and the provision of assurance
• - to those outside the reporting entity

15
External auditing

• Effective reporting and accounting,
• and external scrutiny (i.e., auditing) . . .,
• are essential for effective corporate governance
  
• (Company Law Review Steering Committee,
• 2001, para. 8.1)

16
External auditing

• In order to understand
• - the work, problems and opinion
• of the external auditors,
• we need to appreciate
• - the scope and limitations of financial
  statements.
• And, in order to understand the financial
  statements,
• we need to appreciate
• - the scope and limitations of
• the work, problems and opinion of
• the external auditors.

17
External auditing

• External audit needs to be seen in terms of audit
  of
• - managements motivations.
• The final figures in the financial statements may
  be
• - the result of negotiations between management
• and their auditors.
• Auditors therefore would examine
• - the reasonableness of managements
  justification for their arguments.
• Therefore, to understand the figures in the
  financial statements,
• - it is important to understand managements
  motivations.

18
External auditing

• - Auditing and financial reporting encompass
• a multitude of judgements and assumptions.
• - Auditing is as much about understanding
• (the) accounting data in (its) context.

19
External auditing

• The focus is on the myriad of accounting users
• - The standard setting bodies have gone for
  decision- usefulness of financial statements
  (to users).
• - Auditors do not support this.
• - Company Law Review and Caparo judgemet
• (in law) also rejects this
• Should be focussing on
• - the reporting entity
• - communication of its performance and risk
• Question is
• - How to judge an entitys performance and risk?

20
External auditing

• Question is
• How to judge an entitys performance and risk?
• May be an accounting (financial reporting)
  expectations gap, comprising
• - audit expectations gap
• - financial statements expectations gap

21
Driving forces behind financial reporting
developments

• - Globalisation
• - influence of management
• - extreme market pressures
• - advances in technology
• - knowledge economy has developed
• - fraud
• - independence

22
Driving forces behind financial reporting
developments

• - perspective on information in financial
  statements (F.Ss.)
• - debate about financial performance
• - corporate governance
• - audit developments
• - assurance services
• - real time reporting

23
globalisation

• - a push for international (harmonisation of)
  accounting standards
• - debate over whose standards to adopt.
• - From 2005, listed EU companies now have to use
• international accounting standards
• - (of the International Accounting Standards
  Board, or IASB)
• - IASB was previously IASC
• (see other older lecture notes)

24
globalisation

• - recognition of the politicisation of the
  accounting standards setting process.
• (Armstrong, 1977 Solomons, 1978 Zeff, 2000)
• - (recognition of?) the implications of economic
  consequences of accounting standards and
  policies
• (Zeff, 1978)
• - (need to look at) the political context of
  adoption of
• international accounting standards
• - as well as the accounting context
• - the setting of international accounting
  standards
• is now in crisis!
• (Horton and Macve, 2000, 26)

25
globalisation

• - todays complex economic world requires a break
  from the auditing traditions that have evolved
  from the early balance sheet audit
• (Bell et al, 1997, 12).
• - Especially the emphasis on the business risk
  approach to auditing.
• (Lemon et al, 2000)

26
globalisation

• - Industrial age companies ran on tangible assets
  such as stock, machinery, etc.
• (Elliott, quoted by KPMG, 1999, 18)
• - Post-industrial age companies run on
  intangible assets
• - such as information, human resources and R
  D.
• (Elliott, quoted by KPMG, 1999, 18)
• - We must understand these new ingredients for
  value creation and destruction
• (Elliott, quoted by KPMG, 1999, 18)

27
influence of management

• Management is central to any discussion of
• financial reporting
• - whether at the level of laws (Parliament) or of
• - regulations (accounting standards setting
  bodies) or of
• - official accounting bodies pronouncements.
• (Moonitz, 1974, 64)
• Lack of support from the preparers of financial
  statements
• - for changing the basis of valuation in
  accounting
• (from historic cost to current cost)
• - However, current cost is beginning to
• creep into financial statements

28
influence of management

• However, others (e.g., corporate executives)
• - accuse the accounting standard setting bodies
  of
• having a hidden agenda
• - to undermine historical cost
• - by bringing in piecemeal current cost
• (Miller and Loftus, 2000, 5)
• Concern that accounting standard setting bodies
• - are requiring data that management
• does/will not find useful for its own internal
  use

29
extreme market pressures

• Concern that pressure from capital markets is
• - forcing managements to achieve (ever higher)
• earnings targets.
• - Danger of aggressive earnings management,
• - resulting in shareholders and the capital
  market
• being misled about an entitys performance and
• profitability
• (APB, 2001, 3).
• Recent financial scandals can be seen as being
• - a result of extreme disclosure
• and earnings management.

30
perspective on information in financial
statements (F.Ss.)

• Emphasis is now on providing information
• - so that users of F.Ss. can take decisions and
• - make assessments of the future cash flows of
  entities.
• - users have been actively involved in dialogue
• about accounting principles
• - users are represented on some accounting
  standard setting bodies.
• But should accounting knowledge be
• - articulated by non-acountants?
• - Should the patient tell the doctor . . .?
• (Hines, R.D. (1989)

31
perspective on information in financial
statements (F.Ss.)

• Focus on accounting users
• - Concentration on decision-usefulness of
  financial statements (to users).
• - Auditors do not support this.
• - Company Law Review and Caparo judgemet (in
  law) also rejects this.
• - May lead to unrealistic views about/of what
  accounting can provide

32
perspective on information in financial
statements (F.Ss.)

• - Concentration on future?
• - Or on the past?
• - Cant be both?
• - Government, shareholders, employees want
• - the past - (profits)!
• - Bank(er)s want the future (cash flows)!
• - But - Bank(er)s dont need financial statements
  !
• - They have companys budgets, etc.
• - Key shareholders increasingly
• meet privately with managements
• (Holland, 1997 Marston, 1999)

33
perspective on information in financial
statements (F.Ss.)

• - Anyway, are shareholders all that rational?
• (Scott, 1994, 62)
• - Are stock exchanges all that efficient?
• (Scott, 1994, 62)
• - If not, this threatens the basis on which
  financial accounting
• - Calls for a return to fundamentals.
• Should be focussing on
• - the reporting entity
• - communication of its performance and risk
• Question is
• - How to judge entitys performance and risk?

34
debate about financial performance

• - financial statements include a statement of
  total recognised gains loss
• - but users seem to be ignoring this statement
• (ASB, 2000)
• Should be focussing on
• - the reporting entity
• - communication of its performance and risk
• Question is
• - How to judge an entitys performance and risk?

35
debate about financial performance

• - Is a question of what is meant by performance.
• - Whether just focusing on financial
  performance will really indicate an entitys
  overall performance
• - In management accounting,
• limitations of financial performance
• have resulted in a search for other,
• complimentary indicators,
• such as the balanced scorecard
• (Kaplan and Norton, 1996).

36
advances in technology

• Questioning the relevance of financial
  statements.
• - decision makers, such as potential investors,
• creditors, customers and suppliers
• have asked for (demanded)
• more timely and broader information
• (CICA, 1999, 2)
• - decision makers information needs will be met
• at least in part by
• - real time access to corporate databases
• (CICA, 1999, 2)

37
advances in technology

• Accounting is the instrument used to treat a mass
  of enterprise facts so that the flow of
  transactions becomes intelligible
• (Littleton, 1953, 25)
• A contribution to understanding is made by
  compressing a mass of facts and setting up the
  resulting data in ways that permit comparisons to
  be made
• (Littleton, 1953, 25).

38
advances in technology

• Figures lose most of their significance unless
  the eyes can see quickly whether they are larger
  or smaller than they were
• (Littleton, 1953, 25).
• Double-entry book-keepings relevance has been
  questioned
• (Doost, 2000)
• BUT some sort of accounting system will still be
  needed
• Also, real time reporting could be the ultimate
  in short-termism

39
knowledge economy has developed

• - there is an emphasis on tangible assets in
  financial reporting
• - but is a concern that the financial statements
  may not reflect this development
• - information and knowledge are replacing capital
  and energy as the primary wealth-creating assets
  
• (Enterprise Development Website, 2000, 1)

40
knowledge economy has developed

• - technological developments have transformed
• - the majority of wealth-creating work
• - from physically-based to knowledge-based.
• (Enterprise Development Website, 2000, 1)
• - Technology and knowledge are now
• - the key factors of production.
• (Enterprise Development Website, 2000, 1)

41
knowledge economy has developed

• - We are now an information society in a
  knowledge economy.
• (Enterprise Development Website, 2000, 1)
• - Under 30 of market capitalisation is
  represented by book value.
• (Lindsey, 2001, 117)
• - Over 70 of value is falling outside the public
  measurement and reporting system.
• - This a dramatic shift (reverse) from 20 years
  ago.
• (Lindsey, 2001, 117)

42
corporate governance

• - accountability has long been seen as one of the
  reasons for financial reporting.
• - the importance of corporate governance has
  risen in recent years
• - Company Law Review (2001) which said
• - corporate governance is central to
• - future developments in corporate reporting
• - and accountability

43
corporate governance

• - Need to view accounting in light (context) of
• corporate governance and not other way around
• - And corporate governance encompasses
• much more than financial reporting.
• - In the midst of this, auditors have had to
• respond and to react to criticisms of their
  work!
• (Short et al, 1999)

44
independence

• - the key quality of the external audit.
• - auditors have frequently been criticised for
• a perceived lack of independence.
• - If auditors are not independent,
• the relevance of the audit can be questioned.

45
audit developments

• - there has been a perceived change
• - in the emphasis in the audit
• - from audit efficiency to audit
  effectiveness.
• - one aims to reduce costs,
• - the other is concerned with
• - whether the audit is achieving its objective.

46
assurance services

• - the pressure to add value to the external audit
  
• - has resulted in a consideration of
• - how to extend the audit function.
• - opportunities for assurance services to expand
  to
• - the new types of information used by decision
  makers
• (Elliott, quoted by KPMG, 1999, 18)
• - i.e., independent professional services that
  improve
• - the quality of information, or its context,
• - for decision makers
• (Elliott, quoted by KPMG, 1999, 18)

47
real time reporting

• - real time database approach to external
  reporting
• - has major implications for external auditors
• - the information provided on a real time basis
• - to investors will inevitably raise question of
• - its reliability
• (Panel on Audit Effectiveness, 2000, 172)
• - the perceived need for more timely assurance
• - has given rise to the notion of continuous
  assurance - through a continuous audit.
  (CICA, 1999)
• - users of the financial statements want
  continuous assurance about the systems and
  controls within an organisation.

48
fraud

• accounting history is littered with examples of
  financial information used as a means of
  deception
• (Edwards, 1989, 143)
• fraudulent financial statements are of great
  concern not only to the corporate world, but also
  to the accounting profession. Every year the
  public has witnessed spectacular business
  failures reported by the media
• (Vanasco, 1998, 60)

49
fraud

• These catastrophic events have shocked the
  public, undermined auditors credibility in their
  reporting function, and eroded public confidence
  in the accounting and auditing profession.
• (Vanasco, 1998, 60)
• Detection of fraud is often cited as a chief
  expectation of external auditors.
• Auditors are now expected to plan their audit to
  have a reasonable expectation of detecting
  material misrepresentations arising from error or
  fraud
• (APB, 1995, para. 18).

50
Conceptual framework (accounting theory)

• It is critical there is a firm conceptual basis
  underpinning financial reporting to tackle these
  issues.
• A careful study of the foundations upon which
  accounting has been constructed needs to
  undertaken
• (Ijiri, 1967, ix)
• There are numerous challenges from neighbouring
  areas to accounting
• (Ijiri, 1967, ix)

51
Conceptual framework (accounting theory)

• Accounting has its own way of thinking about,
  observing, and organising business phenomena
• (Ijiri, 1967, ix).
• Accounting has its own philosophy and discipline,
  which have developed over centuries
• (Ijiri, 1967, ix).
• One way of tackling the multitude of problems
  facing financial reporting is to build on
  accounting theory.

52
Conceptual framework (accounting theory)

• Accounting theory and practice are inseparably
  connected, neither can stand alone
• (Littleton, 1953, 1).
• To understand practice fully, we have to
  understand theory
• (Littleton, 1953, 1)
• To understand theory (its integrated structure)
  fully, we have to understand something of the
  totality of accounting practice and of its
  related fields
• (Littleton, 1953, 1).

53
Conceptual framework (accounting theory)

• The changing nature of accounting has
  implications for development of theory.
• What impact will all the developments have on
  accounting theory?
• Practice will change over time.
• Will (should) theory change?
• How far anyway can accounting change and still be
  called accounting?

54
Conceptual framework (accounting theory)

• Accounting theory discussion is usually about
  financial accounting and financial reporting
• But is ill-defined, with broad scope and is
  political.
• Should we think in terms of accounting theory?
• Decision-usefulness has been the cornerstone of
  conceptual (theoretical) developments since the
  1960s.
• Agency theory and communication theory may be
  better conceptual bases from which to view
  financial reporting (according to Higson,
  2005)

55
Conceptual framework (accounting theory)

• - One of the major problems
• (esp. in the Anglo-Saxon business world)
• is that most users are divorced
• from the running of the business
• - so they may not have the appropriate level
• of knowledge to assess their managements
• stewardship of their assets.

56
Acknowledgement...

• Powerpoint presentation by M C Pratt, St Martins
  College, UK.
• Content of slides have been taken directly or
  have been revised and/or amended from
• Corporate Financial Reporting by Andrew Higson
• published by Sage, 2005
• Most points above are notes (which are virtually
  quotes) taken directly from the above text or
  have been taken and then amended and/or revised
  by M C Pratt.
• There are additional points made by M C Pratt.