Financial Reporting Systems and Economic Development - Essay Example

? A sound financial reporting system, supported by high quality accounting standards and backed by a solid regulatory, governance and ethical framework, is a pre-requisite for economic development. The risks related to the management of critical information cannot be doubted. Reference should be made particularly to the information incorporated in the financial statements of organizations worldwide. The development of international accounting standards has been considered as the appropriate solution for ensuring the quality of information related to the performance of businesses, as this performance is reflected in the firms’ financial statements. The role of the financial reporting system, as supported by accounting standards, the law and the ethics, in economic development is reviewed and analyzed in this paper. Particular emphasis is given on faithful representation, as an indicator of the reliability of financial statements. Also, the circumstances under which true and fair override apply are identified and explained. It is proved that faithful representation, in its current form, is something more than simple a compliance with accounting standards. One of the most critical issues when having to evaluate the quality of financial statements is that these statements should achieve faithful representation. In order to understand the role of ‘faithful representation’, as an element of the financial reporting systems, it would be necessary to refer to these systems, as the basis on which a firm’s financial practices are usually based. In accordance with Uddin et al., two major financial reporting systems are considered as the most credible for businesses in all sectors: the US Generally Accepted Accounting Principles (US GAAP) and the IFRS.1 The use of one of these systems, which have been appropriately tested as of the effectiveness in financial reporting, results to the increase of credibility of the local economy. From this point of view, it has been proved that the use of these systems within a particular country leads to the increase of the foreign direct investment (FDI) to the above country. Thus, accounting standards and financial reporting are closely related to the performance of the local economy, of course under the terms that global financial markets are stabilized, i.e. that these markets do not suffer from delays in the implementation of financial and other projects. In the literature the term ‘faithful representation’ has been given various explanations, which are all similar. For example, in the study of Hussey reference is made to the use of the term faithful representation in order to show the reliability of the financial statements involved.2 In other words, the specific term is used in order to indicate the fact that the information included in the financial statements is accurate and responds to the actual financial status of the organization. Apart from reliability, the term ‘faithful representation’ also reflects the completeness of information included in the financial statements.3 The financial statements are considered as complete when they include all necessary information.4 A similar approach in the description of faithful representation is included in the study of Needles et al. In accordance with the above researcher, the term ‘faithful representation’ means that the financial statement involved is ‘complete, neutral and free from error’.5 It is further explained that the phrase ‘free from error’ does not imply the full accuracy of the particular financial statement, as such requirement is quite difficult, almost impossible, to be achieved since financial statements are highly based on estimations.6 At this point, the following problem appears: how the reliability of financial statements is proved? The fact that there are some transactions that cannot be measured, at least not precisely, is highlighted in the study of Hussey.7 On the other hand, the availability of the data involved is an issue that needs to be carefully considered when having to develop a series of financial statements. Indeed, as Hussey supported the information required for the development of the financial statements ‘is not entirely available at the end of the year’.8 This means, that the completeness of financial statements, at least if referring to a percentage of 100% of their content, can be often doubted. The completeness of the financial statements can be also set in risk due to other factors, as for example the following one: most firms use advanced IT technologies in order to ensure the accuracy of their financial data, but the failures that these systems often appear lead to loss of data necessary for the financial statements. The failures in the storage and the management of data within businesses can also set in risk the reliability of data; if due to IT systems’ failures, valuable data are partially destroyed and employees will not identify this problem, then the information used in the firm’s financial statement will be misleading and unreliable, a fact that can result to the punishment of the individuals involved, in accordance with the existing law and the firm’s relevant regulatory rules. Usually, in such cases it is quite difficult for the employees participating in the process, i.e. in the preparation of the firm’s financial statements, to prove that they were not aware of the specific problem. In accordance with the issues discussed above, the faithful representation of financial statements is a prerequisite for the validity of these statements. At this point, the following problem should be discussed: is the faithful representation just a compliance with the existing accounting standards or something more? Carmichael et al. note that accounting standards have been set in order to ensure the quality of financial statements developed by organizations worldwide.9 However, faithful representation, as an aspect of financial statements, is not just a compliance with the existing accounting standards. This view is based on the following fact: the reporting practices of organizations are based on the rules regulating the particular industry; for example, firms operating in the software industry are likely to prefer to align their practices with the US GAAP, as more favourable for the firms of this industry.10 In other words, each firm is free to choose the accounting standards it prefers, at least such option is offered to most countries worldwide. The above fact cannot lead to the assumption that the alignment of a firm’s financial practices with the local law is not necessary. Instead, the financial practices of modern organizations need to be reviewed and, appropriately, tested, especially whether they are aligned with the law provisions on financial statements or not. Moreover, the requirements of faithful representation, as presented above, do not refer to all the firm’s financial practices and requirements, just to the firm’s obligation for submitting appropriate financial statements; the appropriateness of financial statements needs to be discussed by the authorities controlling the relevant process. From this point of view, the faithful representation can be considered as an issue different from the accounting standards; faithful representation focuses on the appropriateness of financial statements; these financial statements may not meet all the requirements of the accounting standards involved but they may respond to all the requirements of faithful representation. From this point of view, faithful representation should be considered as reflecting the quality of the financial statements submitted, while accounting standards set rules which are generally accepted worldwide and which cannot be interpreted in many different ways (its rules are appropriately customized). Moreover, the requirements of the faithful representation are rather flexible, meaning that they can change and be aligned with the accounting standards that are active in the particular region.11 If is for these reasons, that faithful representation is considered to be more than compliance; it rather sets a series of requirements, which however can be partially alternated, in accordance with the conditions in the internal and the external organizational environment, as reflected in the estimations made on the firm’s financial performance. On the other hand, accounting standards are set of rules that cannot be alternated; if a particular set of such rules is chosen by an organization, then the organization has to fully align its accounting practices with the practices of this organization. The above assumption is in accordance with the view of Miller et al.;12 these researchers noted that financial reporting even if it has been used for controlling the quality of financial statements, it incorporates a flexible set of rules and practices which can be used for improving the performance of accounting standards (in all their forms), meaning that these standards would meet more effectively the needs of the organizations that have chosen them as the basis of their financial reporting.13 The alignment of firms’ practices with the international accounting standards is, at a first level, obligatory. However, in case that the information provided through the financial statements is not ‘true and fair’, it is possible for the business involved to ask for exclusion from the international accounting standards; such case exists only if it is considered that the adoption of the international accounting standards would lead to severe mistakes within the firm’s financial statements at such point that these statements would not offer a ‘true and fair view’ of the organization14. In this context, a condition of ‘true and fair override’ can apply; this condition allows to the organization to stop aligning its financial reporting system on the international accounting standards and use instead the local regulation and rules related to the specific activity. In any case, such option is rather difficult to be justified, especially when the financial statements of the organizations have been already checked by the relevant authority and have been found as inappropriately developed. It should be noted that in certain cases the violation of the international accounting standards is considered as necessary when the financial results of the organization do not ‘meet the expectations of investors’.15 However, such practice leads to severe organizational problems, since, sooner or later the particular strategy will be revealed. On the other hand, severe market turbulences may cause a radical decrease of the organizational performance, which can severely affect the firm’s image in the market, if the relevant figures are published. In the last case, the firm’s financial managers could choose a ‘true and fair override scheme’ in order to avoid the exposure of the organization to extremely strong market pressures. For instance, if the use of international accounting standards could harm the organization because of the radical differentation between the global and the local economy, then a ‘true and fair override’ scheme could be used for reflecting the actual status of the firm within its market. In a country with strong financial turbulences or with high market instability caused by political or social conflicts, which are likely to be temporary, such practice could be valuable for promoting stability in the country’s various industries. In any case, the quality of corporate financial reporting is an indicator for the potentials of the organization to survive in the global market. However, today financial reporting has been differentiated compared to the past. Traditionally, financial statements have been focusing on key financial data, including estimations for the firm’s financial performance in the future. Currently, valuable information on the firm’s employees and the community is also incorporated in financial statements showing a change in the role of these documents.16 The above fact leads to the following problem: as long as financial statements have been related only to financial data, it has been easier for the authorities to check them as of their reliability. Financial statements in their current form are difficult to be reviewed and evaluated; the identification of problems related to the faithful representation of the financial statements has been a challenging task. In this context, it is quite difficult to judge whether the independency of a firm’s financial reporting systems from the international accounting standards, i.e. a scheme of ‘true and fair override’, should be allowed or not. At this point, the following issue should be highlighted: the evaluation of the ‘faithful representation’ of financial statements as also of the potentials for choosing a ‘true and fair’ override scheme can be problematic mostly when the the principles governing a particular market are differentiated from those applied in other markets worldwide. For instance, in common law countries, the priorities of legislators are the promotion of the market’s interests, rather than the banks’ interests;17 also in these countries, ‘accounting rules are independent from tax rules’.18 In this context, choosing the accounting standards which best reflects the structure and the needs of a specific organization can be a difficult decision especially since the strong turbulences in the global market require long – term plans that promote stability and coherence, meaning the alignment, as possible beetween the organizational practices and the international accounting standards. Bibliography Alexander, David, Britton, Anne, Jorissen, Ann. International Financial Reporting and Analysis. Belmont: Cengage Learning EMEA, 2007. Carmichael, Douglas, Whittington, Ray, Graham, Lynford. Accountants' Handbook: Financial accounting regulations and organizations. Hoboken: John Wiley and Sons, 2007. Gee, P., Spicer, E., Pegler, E. Spicer and Pegler's financial reporting for business and practice 2004. London: Gulf Professional Publishing, 2004. Hussey, Roger. Fundamentals of International Financial Accounting and Reporting. London: World Scientific, 2010. Miller, Paul, Bahnson, Paul. Quality financial reporting. Berkshire McGraw-Hill Professional, 2002. Needles, Belverd, Powers, Marian. Financial Accounting. Belmont: Cengage Learning, 2010. Rezaee, Zabihollah, Riley, Richard. Financial Statement Fraud: Prevention and Detection. Hoboken: John Wiley and Sons, 2009. Roberts, Clare, Weetman, Pauline, Gordon, Paul. International financial reporting: a comparative approach. Essex: Pearson Education, 2005. Uddin, Shahzad. Corporate Governance in Less Developed and Emerging Economies. Bingley: Emerald Group Publishing, 2008. Read More