Financial Accounting. Relevance and Reliability - Dissertation Example

? Financial Accounting Table of content Introduction 3 Purpose of the financial reporting 3 Relevance and Reliability 5 Contribution of relevance andreliability on financial reporting 7 Application of different valuation methods 12 Conclusion 15 Reference 17 Introduction Relevance and reliability are the two qualities that distinguish better or more useful information from inferior or less useful information. The main objective accounting policies and standards is to produce fair valued accounting information that is reliable and relevant to the purpose of the financial statements. Financial information of any company is presented in financial statements. Financial statements are the main components of company’s annual report. These statements need to have fairly representation of the financial details which is responsible for the decision making process of the investors, suppliers, creditors etc. relevance and reliability are two most important characteristics of financial statements of any organizations. These two factors determine the quality of financial statements. The main purpose of the financial reporting is to provide fairly valued and audited financial details of company for its stakeholders. According to these settlements the actual; worth, performance, profitability, growth rate etc are determined. So, a financial statements needs to be relevant to the valuable decision making requirements of the users. Depending on financial statements, millions are invested to companies by the investor daily. So, relevance and reliability of financial statements are very essential to the users of financial statements. Purpose of the financial reporting There are two broad purpose of financial reporting, external and internal. External purpose includes the investment decision making by the shareholders and potential new investors of a company, credit rating analysis of company by the credit rating agencies and also by the creditors like banks and other financial institutions, suppliers, government and regulatory bodies like taxation department of government. Internal purpose of financial reporting is to make a standardized record of the financial activities by a company so that it can evaluate its performance at the end of a quarter or a financial year. From the evaluation of the financial statements the companies make decision and develop strategies or change strategies and activities for the next quarter or the next financial year. Financial reporting provides information to the investors, creditors, suppliers so that they can assess the timing, amount and uncertainty of a business entity’s performance in terms of future cash inflow and cash outflow. The elements in financial statements are very important to analysis the ability to generate net cash inflow by a business. This is one of the important characteristics of a business which directly influence the return on the investment of the existing investors of a business and it is also the key important factor to the potential investors by which they are generally influenced to invest in company. Financial reporting is the important part of the valid contract between a stakeholder and an organization. The stakeholder may be any individual or other institutions who are directly or indirectly related to a business entity. A financial report must needs to accomplish some key important factors or characteristics of a business. The main factor is the business is making profit and loss and the amount of profit or loss. Secondly, how much assets the company has to cover its liability and the quality of the assets the company. Third, financial statements provide information about the source of the capital that the business use and efficiency of the business in terms of effective use of the capital so that it can generate substantial return of capital used. Net cash flow of a business is directly influence the return for the investors of a business so it is another important factor of a business which financial statements provides detail information of it. Financial statements are the financial written indicator o the financial position of a company. Financial statements published in the company websites are taken as trusted indicator of financial status of a company. Businesses often assume that the users of the financial statements are knowledgeable enough to understand the financial condition of the company so that they can analyze the financial statements to make their valuable investment demission. So, they except valid, ethical and fairly valued financial reporting from the companies where they want to invest. Apart from the investors, there is another important stakeholder of the company is suppliers who also the key audience of financial statement. Suppliers provide highly valued goods and services to the companies in credit even in a long term credit period. They only trust a company by the financial stability of the company which is determined by the financial statements. So, financial reporting needs to provide truthful dates from where the financial condition of a company. Relevance and Reliability Relevance and reliability are the two most important qualities of financial statements that every company needs to follow for financial reporting. Relevance means some particular facts, data or information which is useful to a particular purpose and the decision maker can take into consideration these information or data for making valuable decision making. Any information may be relevant at a particular time and the same may be not relevant in other time when it is not required. So, relevance is a quality which must be emphasized in all accounting framework. It is a qualitative characteristic of financial reporting which consists of mainly predictive value, timelines and confirmatory value (PSASB, 2001, p.9). Reliability means the quality of information which assures the users that reliable information must be free from error and any biasness and it is faithfully represented so that it achieve its purpose or goal. The main components or ingredients of reliability are faithful, trusted and verifiability. A faithful representation refers to an agreement between the publisher and the user that the user can make any financial decision based on the information or the statements. Reliability consists of verifiability and audited by some authority. For example, provision for bad debts is deducted from the receivables and the final amount is collected from the debtors. Now, if the provision is too low then a lot more amount might not be collected from the debtors. So, this figures is not does not provide a reliable information or financial status as it does not faithfully represents the receivable amount. Management and prepares of financial statements in companies always need the historical values so that they can measure the performance of the company by comparing with the past performance of the company. Recording historical values help the auditors to verify the financial statements published by the company. Verifiability of financial statements by authorized auditors places higher importance on reliability of the information in the financial statements. On the other, creditors and investors always favour and also except recording more representative fair value of the financial activities done by the company so that they can determine actual financial condition or financial health of a company. According to GAAP, an asset should be fairly valued based on the price at which the assets can be bought or sold in a recent transaction between the participants or buyer or seller at the marketplace in the reference market. The investors and the creditors are interested in the current market price of assets rather than the historical price. Fair value measurement in financial reporting make investors and creditors better informed about the current financial status of a company. It makes financial evaluation methods, financial ratios more meaningful and relevant. Contribution of relevance and reliability on financial reporting Relevance and reliabilities are two different qualities of financial reporting or financial statement. Basically the users of financial statements desire for reliable and relevant information for their financial decision making. These two characteristics are not interdependent that means if one presents another may be or may not present in a financial reporting. The investors generally want the information to relevant to investment analysis and the source of information to be reliable. Both these characteristics have similar important these two are most important characteristics of financial reporting that determiners the quality of a financial statements. For example, if relevance is more important than reliability financial statements only record the current values then that would not mean that the financial reporting is not reliable even there would be some difficulty in terms of reliably determine the asset’s worth because sometimes companies having assets which have not active market. For example, if an investment is done on shares then the value of the investment is considered by the closing value of the shares in that investment. One of the tough assets to evaluate is land because there is no indices have been made for land prices. It is very subjective to evaluate the land prices. Though the recorded value is taken into consideration for subjective one, it satisfies both the quality of financials reporting that means both relevant and reliable. So, by implementation of fair value accounting, the financial information would have better extent of reliability and relevance. Having the trade off which would positively influence the usefulness of financial information in investment decision making process, has to take into consideration. Accountants and financial experts are involves in various deferral and accrual methods like prepayments. These types of calculations produce approximate numbers which are not totally reliable. In case of recording historical costs, the accountants and the financial experts should concern about the fact that the financial statements should not be made by estimates or any future projections. It is only representation of the business activities like sales, purchase etc for specific time period of business operation and in a standardized format. Use of estimations in financial reporting in terms of recording historical cost reflects the mathematical constructs. It does not reflect and represent the true economic value of a firm. This type of representation does not provide reliable information though accounting is mathematics like having zero assumptions in exact science. The companies report the financial values in simple numbers not infractions. So, generally, there is a big difference in the fair values and the historical based measures of assets. For example, an asset may have a book value zero but its fair value might be 1000. Another important factor of financial reporting is historical cost which also has a major influence on the overall quality of financial statements. As, time is one of the most important factor or component of both relevance and reliability of a financial statements, it also influence the extent of relevance and reliability. This is because, as time goes on the information published by the companies become outdated and become less relevant to the current investment decision making. So, historical value will be less faithfully and also relevant to the current economic value of a firm. For example, stock price of a company generally rises on the day when the company publishes financial results for the current financial year. In recording fair values of accounting, price is generally estimated at market referenced price and it is also the best price to esti8mate fair value. But sometimes these would not be possible as some typical assets might not have a current active market. In this case the assets are measured only based on historical values. This type of financial reporting is not reliable and relevant current financial decision making. The investors, in many cases make these mistakes by considering these type assets and chances of inefficient investment decision. There are many companies who consistently practice unethical business practice in term s of increasing the fair value of the current of the company so that the current valuation of the company would increase. Apart from all these negative sides of the relevance and reliability of financial statements, fair value measurement has introduce huge volatility in the financial figures and also company’s stock price. So, relevance and reliability of financial reporting depends on the fair value measurement of all the financial components of a firm. Thus it will minimize losses of the investors, increase the consumers’ confidence level and represent an ethical business practice which is the most important corporate responsibility of a company to its major stakeholders. Dilemma of financial reporting All the companies residing in UK and US follow the GAAP (Generally Accepted Accounting Principles) which has been established by FASB (Financial Accounting Standards Board). The main purpose of adopting the GAAP is for taking investment decisions which are based on the generalized principal of accounting throughout the world. But it becomes very cumbersome to apply all the decisions in the GAAP thus increasing the cost of preparing the accounts and the audit of the same thereafter. Measurement problem is another dilemma in financial reporting as the numbers recorded in the financial statement of the company may not be a precise one. More over the accuracy of the recorded numbers is not guaranteed hence may not be understood by a layman going through the financial report of the company. The disclosure of the contingency of the liability of the company may or may not be accounted for depending on the probability of its occurrence. Since the financial statements of the company are based on the historical costing system hence it cannot be completely depended upon. But the relevance and reliability principal is in the favour of fair value accounting. With the changing strategy and the management of the company the future scenario of the company may be different. There may be fluctuations in the revenue value of the related company due to artificial prices of the transactions with concerned parties. Based on the various terms and conditions on which the costs and savings of the company is calculated may be different in different years as well as the other company to which the financial records of the concerned company is compared. A company which deals in seasonal products their accounting period may be different to that of the other firms. As the companies are often subjected to window dressing the year-end figures of the financial statement are not representative due to various adjustments. The major asset acquisition of a company may result in the financial statement of the company to show less sales revenue and depreciation charges not projecting the true value of the company. Even the inflation in the economy is a factor affecting the valuation of the data in the financial statements of the company. All the relevant information of a company is not always obtained from the information thus provided by the financial statement of a company. The ratios used for the financial analysis of one company may not be the same for that of another company. Hence the financial statements of both the companies may not be the same as a result of which comparison between companies becomes impossible. The financial system adopted in most financial systems of the company is creative accounting system which may lead to fictitious results of the company not portraying the true value of the company. Thus the techniques adopted by analysts are also restricted to the adoption of the particular ratios for studying the financial statements of the company. When the accrual system of accounting is adopted by some modern companies their financial statements are based on the occurrence of the transaction. The companies following the accrual system don’t wait for the payment of cash. Judgment of the company’s performance based on its financial statements at times may prove to be wrong because the company whose shares in the market have fallen may be performing much better than the company whose stakes in the market have risen. This happens because the volatility in the market. Financial statements of different companies are prepared at different period of time which is again a reason for the limitations of the financial report. The terms relevant and reliable have two different meanings, i.e., the concept of accounting adopted is appropriate to the present economic scenario while reliable means the exact valuation of the firm. Generally the principal of relevance is more applicable than the reliable factor as the mode of calculation may be different for different firm resulting in dilemma of the financial report of the company. Both the concept of reliability and relevancy of the financial reporting are not possible in most cases. The peaks and troughs of the various economic stages is the reason behind the lack of coexistence of the two concepts in the financial reporting of the concerned company. However, the preparers place more importance with the reliability of the accounting values to pass the audit. Though the importance of both the terms in financial reporting is necessary yet it is not practically possible to maintain the same. Both the concept of reliability and relevance are important from their own perspective but depending on the present market scenario the implementation of the same needs to be done. Mostly the application of both the terms though required is not possible to implement. But in the research conducted recently the trade-off relation between the relevance and reliability of a company’s financial report has been proved wrong showing that the existence of the two concepts is possible (Chen, 2012, pp.1-2). Application of different valuation methods The concept of relevant is useful to the company only when it is capable of making a difference in the decision to be taken by the company in its favour. By reliability we mean the quality of information that is completely free of any kind of mistakes or nepotism but followed by faithful representation, verifiability and neutrality. The combination of these two concepts is very much required in the formation of the financial report. Though the weight age of reliability is comparatively more yet the information obtained beyond the financial reporting of the firm is equally important. Reliability of a data is the means for achieving the relevance of the financial report. Thus choosing the benchmark for recording the value that lies close to the benchmark is the responsibility that rests upon the information obtained along with the creation of role between the fundamentals. Thus based on the relevant accounting information the process of reliability of the firm can be confirmed. The analysis of the financial statements is very important as based on this the financial reporting of the company is done. But again to maintain the concept of reliability and relevance in the financial reporting of the company a few methods of valuation is to be adopted by the company. Most importantly is the fair value calculation of the company which is supported by both the concepts of reliability and relevance. The current exchange value adopted by the firm helps to reflect the firm’s asset contribution in respect to the current market values of the claim of the company’s earnings. Thus the fair value of the company helps provide investors and others interests in the financial report of the company to obtain more important information than the historical costs of the company in determining the valuation of the firm’s investments. Moreover the relevance and reliability based on the historical cost exists only for a day whereas in case of fair value system the concept of reliability and relevance is continued for a long time. The horizontal analysis carried by the company is very useful as the comparative cost of the company can be judged by the company. On knowing the exact cost of the company the profitability of the company can be well measured. The process of dirty surplus accounting is another method of overcoming the divergence of relevant and reliability of financial reporting. Under this system of accounting the unrealized profits or losses of the company does not affect the net income reported directly in spite of the fact the assets and the liability valuation will be in close association with the stock prices. The application of the dirty surpluses helps in the value addition to the balance sheet of the firm without neglecting the figures in the income statement which leads to a win-win situation for the company in all perspectives. Another method adopted by the financial reporting for the maintenance of relevance and reliability in the financial reporting is the accrual and value relevance model. The main purpose for the use of the accrual models is to measure the extent to which the management can yield earnings under the current rules and legislations made by the FASB. Under these models the assumptions made are the use of the discretionary use of the accruals of the company, i.e., the accruals over which the manager can practice some control in order to manage the earnings of the company. This method is advantageous in the sense that it enhances the financial reporting of the firm based on the information present in the annual report of the company. The relevance and the reliability of the company are well maintained by the adoption of accrual models. The quality of the information thus obtained from the annual report of the company is well enhanced by the adoption of the value relevance method as this method focuses on the relation between the accounting figures of the company and the stock market variations. Thus a proper framework is to be adopted by the concerned firm to enable the existence of both reliability and relevance. The existence of both the concept in a firm helps the company to provide information which is not only dependable but also at par with the present economic scenario of the company which enhances the reliability of the information thus provided by the company. Hence the company only sticking to either of the concepts of relevance or reliability is lacking the touch of the modern techniques that are to be implemented by the organizations. This will even be effective to the fact that the stock prices of the volatile market be well analyzed in tandem with the present financial status of the company based on verifiability, neutrality and performance (Kim & Lim, 2006, pp.1-9). Conclusion The present situation of the economy is such that more usage of the fair value measurements is required in the financial statements of the company as the implementation of the same will enhance the relevance of the company’s information to the investors. The existence of relevance as well as reliability during financial reporting of the company should possess the same weight for the appropriate financial measures to be adopted. The existence of both the terms will result in reflecting a better picture of the financial records of the company in tandem with the facilities thus provided by the company which will help it to have better knowledge about the past and the present financial status of the company. The various tools suggested for the implementation of both relevance and reliability should be practiced according to the market scenario. By used of the prescribed methods consistency will be maintained with the quality of financial reporting in order to take useful decisions for the company. Even the validity of the results generated from the procedures should be established by comparing the measured results of the useful decision of the financial reporting as is perceived by the shareholders of the company like the equity providers and the lenders. But the situation where the limitations of parity between the coexistence of relevance and reliability arise under two fields namely, the timeliness and costs versus benefits. The financial information possessing both the reliability and the relevancy of the subject may lose the relevance during the materiality test undertaken due to delay in the information being recorded. Again, the major crises faced by the preparers and others are that the cost of providing the related information of the company may not justify the benefits derived from it. Thus probable measures need to be undertaken for the implementation of both the terminologies during financial reporting of the concerned firm. Reference Chen T. T. Y., 2012. The Dilemma of Measurement in Financial Reporting. Available at: [Accessed on 21 June 2012]. Kim O. & Lim S. C., 2006. Reliability As a Means to Achieve Relevance in Valuation: Does Historical Cost Qualify As “What It Purports to Represent”? Available at: [Accessed on 21 June 2012]. PSASB. 2001. Qualitative Characteristics of Financial Information. [Online]. Available at: [Accessed on 21 June 2012]. Read More