Significance Of Financial Reporting
Length: 1613 words (4.6 double-spaced pages)
The Collapse of the Corporate Giants like Enron and WorldCom have raised the imminent question, which always remains in the back of an investor¡'s mind, "Can I trust my hard earned Capital in somebody else's hand?" This is not the first time that investors have lost their trust in companies however the fact does not change that the cost of capital from the market has increased significantly for the companies. Investors have started to invest their capital in risk free securities rather than in company stocks.
Investors have also started to look with contempt and doubt at a company¡¦s financial reports because some of these collapses were preceded by financial frauds cleverly covered by the management of such companies. Investors have arrived to a stage where they no more trust the financial reports provided by the company. However some of the intellectuals believe that financial reporting is of no significance for investment decisions. The reason being the fact that most of the financial reports are historical and they have already been taken into consideration while deciding the price of the stock of the company and it also does not give an idea about the future position of the company.
On the other hand there are also some intellectuals who argue that there are still a lot of investors who still takes their investment decisions on the basis of a company¡¦s financial reports. Ask investors what kind of financial information they want companies to publish and you'll probably hear two words: more and better. But let's face it, the financial statements of some firms are designed to hide rather than reveal information. So what would ensure investor¡¦s trust in companies and its governance? The answer is a good, future oriented and more transparent financial reporting system.
One cannot deny the importance of a good financial reporting system for ensuring sound corporate governance. There is now a clear need to restore confidence in capital markets and elsewhere by enhancing corporate governance in order to provide financial information of the highest quality.
The lifeblood of markets is information and barriers to the flow of relevant information represent imperfections in the market. The need to sift and correct the information put out by companies adds cost and uncertainty to the market¡¦s pricing function. The more the activities of companies are transparent, the more accurately will their securities be valued.
A basic weakness in the current system of financial reporting is the possibility of different accounting treatments being applied to, essentially the same facts.
The consequence of that would be different results or financial positions each of which would apparently comply with the overriding requirement to show a true and fair view. However the investors might not get the real picture behind the numbers which put them to a disadvantage and they would not be in a position to see through the techniques used by the management to show the results of the company in the most favorable and flattering way.
That¡¦s why a stricter and more elaborative financial reporting is very much essential because it discourages managements intentions and besides that there are a lot many advantages to the investors, analysts and other accounts users and ultimately it also benefits the company itself because it limits the scope of uncertainty and manipulation. In addition to that the wider the scope for alternative treatments the less useful financial reports become in terms of comparability thus a uniform set of generally accepted accounting principles and practices is necessary.
What investors look for in an accounting report is a coherent narrative (supported by the figures) of a company¡¦s performance and prospects. In order to ensure that the responsibility should be placed on the Board of the Directors and they should pay particular attention towards presenting a balance and understandable assessment of their company¡¦s position.
Furthermore the fundamental principle of financial reporting is that the view presented by the reports should be true and fair. And further principles suggest that board of directors should aim for the highest level of disclosure of the facts which are understandable by avoiding damage to their competitive position. They should also aim to ensure the integrity and consistency of their reports and they should also meet the letter of the reporting standards such as GAAP.
Here the Investors should seek disclosure and simplicity. The more companies say about where they are making money and how they are spending their resources, the more confident investors can be about the companies' fundamentals. It's even better when financial reports provide a line-of-sight view into the company's growth drivers. Transparency makes analysis easier and thus lowers an investor's risk when investing in stocks. That way you, the investor, are less likely to face unpleasant surprises.
As per the views of George Bennet Stewart III of Stern Stewart & Co. the current Accounting Practices are of no use in determining a company¡¦s current position. In the United States of America, President George Bush has created a new oversight board to regulated accounting standards. But according to Bennet these reforms just solves some of the problems but they do not provide a full fledge solution.
Here the main problem is not with companies like Enron and World Com who broke certain rules the root of the problem is that every company is working on the boundary lines set by the government. The idea is to bend the rules to the maximum and finding a way around the legal requirements. Bennet suggests some extreme measures to reform the accounting practices but that certainly would not cost beneficial to the companies.
On the contrary George J. Benston of Emory University suggests that accounting is not in need of fixing it is just needed to be reinterpreted. Benston agrees with some of the suggestion by Bennet but he totally denies the motion of altering the GAAP from the root. In support to his arguments he describes the importance of traditional accounting system. He explains that the traditional accounting practices did not put an emphasis on measuring and reporting the current market values of balance sheet accounts or changes in these values over the period. Instead the primary aims of the financial reports the audits were firstly to detect theft or gross misuse of the resources and secondly to ensure that the earnings generated by those resources were measured and reported fairly and consistently over time in accordance with GAAP.
Financial reporting is not just important for investors. One should always know the importance of financial reporting to the capital markets because investors, creditors, regulators and other market participants rely on getting accurate, timely and comparable financial information from public companies. The efficient allocation of capital depends on financial reports that provide a realistic picture of company¡¦s past performance and future prospects. When the information provided draws a misleading picture than the results could be disastrous as seen in the failures of Enron and World Com.
Why there is a need of accounting reform whereas the system has been successfully operated over a period of time? The answer to that is the slow rate at which accounting standards evolve. The Economy had and is evolving at a rapid pace while reporting standards have changed to a very little extent. In fact they never changed they were just modified so to avoid the imminent problem for the time being.
One should know that developments in accounting historically have been slower than business developments and the task of setting standards is not an easy one. To ensure that accounting standards keep pace with business developments, the government must continually reassess the answer to the ultimate question, "What do investors really need to know?" Obviously, investors need accurate and relevant historical information, but it would also be helpful to know the key drivers of the business and the risks the company faces.
GAAP cannot ensure the providing of the most relevant information to investors for making decisions about the true value of the company. For example, many companies now derive much of their value from intangible assets. GAAP ¡X which does a relatively good job of reporting the cost of tangible assets, such as a company's equipment ¡X is less effective in providing relevant information on intangible assets, such as technology rights, human capital, and innovation. As a result, the value of huge sectors of the economy may not be accurately reflected by financial reports.
As GAAP is not designed to provide some of the information that today's investors might find most relevant, the investors need to focus on improvements in business processes and business reporting that make the desired information available. This additional information could, for example:
æ The information provided by GAAP should be enriched further by giving additional financial information like performance metrics, operational data, macroeconomic or industry-specific data or other information;
æ The companies should also provide the context for the analysis of GAAP financial statements;
æ The Risks and drives that allow better evaluation of the quality of earnings and cash flows should be identified and explained to the investors.
All these motions and arguments for reformation or reinterpretation of the financial reporting one thing that remains unquestionable is the significance of financial reporting in order to secure investors¡¦ trust and for that matter to ensure good corporate governance. However as we discussed earlier that there is still a need for some reforms and reinterpretation needed while preparing the financial reports.
æ George J. Benston, Corporate Governance at the Crossroads: A Book of Readings, McGraw Hill Irwin, 2003.
æ George Bennet Stewart III, Corporate Governance at the Crossroads: A Book of Readings, McGraw Hill Irwin, 2003.
æ Christine A. Botosan, Corporate Governance at the Crossroads: A Book of Readings, McGraw Hill Irwin, 2003.