Reasons for Firms to Adopt Consolidated Financial Reporting - Coursework Example

EVOLUTION OF CONSOLI D FINANCIAL REPORTING: AN ANALYSIS OF UNDERLYING REASONS 0 INTRODUCTION: Accounting is major means of helping mangers to administer each of the activity or functional areas for which they are responsible and to coordinate those activities or functions within the framework of the organization as a whole. (Horngren, Foster and Datar 2000) Basically 'Accounting' provides information for three major purposes: Routine Internal Reporting for the decision of the managers and this reporting will enable the managers to take decisions that occur with some regularity. Non-routine Internal Reporting for the information of the managers providing tools for taking decisions concerning issues that occur irregularly or without precedent. External Reporting to investors, government authorities and other outside parties on the organisation's finance position, operations and related activities. This information is also used by regulatory bodies like Internal Revenue Service. Sometimes the managers in other organization also use such information in their decision making. Each major purpose of accounting often requires a different way of presenting or reporting the information in the accounting system. In this scenario, it may be emphasized that it is a vicious circle in that there are managers in organizations who affect accounting and such accounting in turn affects people's behaviour. The impact of accounting reports on the decision making behaviour of business, government and creditors is termed as the 'economic consequences' and the world has seen the worst of such consequences because of the bad reporting as in the case of 'Enron Corporation'. It may also be observed that such external reporting had given rise to the preparation and presentation of consolidated financial and non-financial statements. Several arguments have been flowing around about the very purpose behind the merits and demerits of such consolidated statements. In this context, this paper attempts to draw an overall picture of the position of the consolidated statements in relation to decision making by the stakeholders vis--vis the presence of the consolidated statements as a deterrent factor to have a clear understanding of the decision making process. 2.0 POSITIVE ACCOUNTING THEORY: "Management wealth, it is argued, is a function of changes in share prices (via stocks and stock options), and changes in cash bonuses (via compensation plans). Ordinarily, managers are predicted to have greater incentives to lobby for accounting standards that lead to increases in reported earnings and thereby management wealth." (Markus J. Milne) It is more than normal that managers indulge in enhancing the reported earnings to strengthen their positions in the organizations higher echelons. Positive Accounting Theory studies the manager's accounting policy choices as part of the overall process of corporate governance. Under this theory Positive rather than Normative accounting policies are chosen strategically. 3.0 REASONS FOR FIRMS TO ADOPT CONSOLIDATED FINANCIAL REPORTING: This part of the paper analyses the various reasons why a firm may decide to resort to consolidated financial reporting. The decision may be partly due to the statuary obligations placed on the firm and partly on the managers' decision to go with the publication of consolidated statements. Statutory Regulations as a reason for publication of consolidated financial statements: Earlier studies (Whittred 1986, 1987, 1988) concluded that the regulations did not have much impact for the firms to resort to consolidated financial statements, whereas the contracting cost variables were the major determinant for publication of consolidated statements. However later it turned out that Regulations did play a major role in compelling the firms to adopt publication of consolidated financial statements. "The introduction of tax legislation permitting the presentation of consolidated returns seems to have been a significant factor in widening the profession's awareness of consolidated statement." (R.G.Walker and Janet Mack 1988). Similarly the listing requirements of various stock exchanges world over have led the companies to prepare and file consolidated statements for the wider information of the shareholders and stakeholders. "Support for the use of the consolidated statements by banks came from the New York Stock Exchange which in 1919 introduced listing rules requiring the presentation of either consolidated statements or the separate statements of all constituent companies" (R.G.Walker and Janet Mack 1988) Starting from 1919 various regulations have dealt with the presentation of consolidated financial statements and these regulations affecting the preparation of consolidated statements have become more perspective and authoritative over time. Findings of study on the reporting practices of the 779 non-mining companies listed in the Sydney Stock Exchange as at 1st January 1958 that the wider adoption of consolidation of accounting has been associated with changes in statutory and other forms of regulation. Why Companies adopt to consolidation of financial statements - Reasons other than Regulatory compulsion: It was considered that the primary factor driving the wider use of consolidation accounting was a response to private contracting between companies and their creditors to minimize agency costs. Similarly the reason for wider use of consolidated statements was also identified as the increasing reliance of listed companies on debt and the contractual arrangements with the creditors might have influenced the companies to prepare and adopt consolidated financial statements. The firms opt out for non-consolidated financial statements owing to Operating Interdependence, Information Interdependence and Financial Interdependence. "The FASB argues that an important aspect of the use of unconsolidated financial subsidiaries is that the procedure keeps the subsidiary's debt off the parent's balance sheet" (Shehzad L. Mian and Clifford W. Smith 1990) (FASB is the Financial Accounting Standards Board). "The off-balance-sheet financing hypothesis has two components: (1) unconsolidated financial reporting causes users to form biased estimates of the fixed claims in the parent firm's capital structure, and (2) firm's use of unconsolidated financial reporting is motivated by an incentive to exploit this bias." - (Shehzad L. Mian and Clifford W. Smith 1990) Mostly to prepare the financial statements of the holding and subsidiary companies are the decisions taken by the managers depending on the organizational structure concerned. With the given choice it appears that the firms will choose to report on an unconsolidated basis with approximately the same frequency as on a consolidated basis. "The evidence indicates that a firm is more likely to choose to report the performance of a financial subsidiary on a consolidated basis: (1) the greater the operating, financial, or informational interdependencies among the parent-subsidiary activities; (2) in the case of foreign subsidiaries rather than domestic; (3) when the parent provides a direct guarantee of the subsidiary's debt rather than an indirect guarantee; and (4) when the parent is in the financial services industry." (Shehzad L. Mian and Clifford W. Smith 1990) Why Would Companies Voluntarily Adopt Consolidated Financial Reporting: The Practice of consolidated financial reporting became common in Australia during the early 1950s. The practice accumulated widespread adoption with the removal of Capital Issue controls. "Thus between 1930 and 1950 fundamental changes occurred in both the way in which firms organised and in the markets in which they competed for capital. Corporate and capital structures became increasingly complex."- (Greg Whittred 1987) The study of Whittred 1987 identified several incentives for the companies to adopt consolidation of financial statements. Some of them are: Debt Related incentives: "With risky debt outstanding, management, acting in the shareholders' interest, has incentives to design a firm's operating characteristics and financial structure in ways which benefit shareholders to the detriment of debtholders." Greg Whittred 1987 Issuing claims to the same or higher priority than the debtholders' claims, assumption of a 'quasi debt' by a corporation, the transfer of assets to a third party at arm's length and raising of debts from subsidiary companies were used to cover the financial statements to display a reduced coverage of the debtholders' claims. Equity Related incentives: The separation of control from ownership based on agency theory has also contributed to adopt to consolidated financial statements depicting a rosy picture of the company's financial position. However problems may occur when the shares in the subsidiary companies constitute the principal asset of the parent company. "In these circumstances the difficulties of evaluating managerial performance on the basis of parent company income or rate of return alone are obvious; particularly when the principal source of parent company income is inter-company dividends, the amount and timing of which are largely at management's discretion." Greg Whittred 1987 The financial statements are required not only for managerial incentive structure but also required for internal control and monitoring of the enterprise. Cost factors affecting the consolidated financial reporting: The Costs of preparation, auditing and printing of the consolidated financial statements will also have a say in the publication of such consolidated financials statements. Ex Post Opportunistic behaviour aspects: "Taking the contractual structure of the firm as given, managers are assumed to change accounting method to either avoid the costs associated with violating restrictive covenants or to expropriate the wealth of other claimholders." - Greg Whittred 1987 This is another significant reason why managers would change the accounting and presentation methods. Based on the strength on the contractual arrangements they possess the managers are bound to take decisions on the accounting policies. 4.0 CONCLUSION: "Thus very few listed companies could be said to have voluntarily presented consolidated statements independently of regulatory influences". (R.G.Walker and Janet Mack 1988) With the geographical diversion of the companies and their phenomenal growth accentuated by the growth of the economies in the past decades, the companies managing their operations hitherto with a single branch or division have grown bigger. The growth in their operations, the increase in size, increase in diversity of operations and internationalization of the business - all would have contributed to the evolution of complex business structures which in turn would have necessitated the consolidated financial statements to be prepared by the companies for their own internal control measures. Quite obviously this would have been extended for the external reporting. Coupled with this the additional regulatory requirements might also have necessitated the firms to employ the publication of consolidated financial statements. Apart from these reasons, the evolution of the knowledge of the practitioners of accounting would also have contributed to the development of meaningful consolidated financial statements over the period of time. Thus it may be concluded that the publication of detailed and consolidated financial statements has been the result of an evolution process in which the regulations as well as the intention of the individual firm to consolidate their financial statements have played significant roles. Reference List: 1. Charles T. Horngren, George Foster and Srikant M. Datar 2002 Cost Accounting A Managerial Emphasis Edition X Prentice Hall Inc. 2. Markus J. Milne Positive Accounting Theory, Political Costs and Social Disclosure Analyses: A Critical Look University of Otago [online] Available from: http://www.business.otago.ac.nz/acty/research/pdf/postive_accounting_theory.pdf Accessed on 27th January 2007 3. R.G.Walker and Janet Mack 1988 The Influence of Regulation on the Publication of Consolidated Statements ABACUS Vol 34 No 1. 4. Shehzad L. Mian and Clifford W. Smith 1990 Incentives for Unconsolidated Financial Reporting Journal of Accounting and Economics 1990 vol 12 5. Greg Whittred 1987 The Derived Demand For Consolidated Financial Reporting Journal of Accounting and Economics Vol 9. Read More