Pros and Cons of Financial Reporting Regulation - Coursework Example

Pros and Cons of Financial Reporting Regulation and A Comparative Financial ment Analysis Report of WM Morisson and Tesco of Subject Name of Professor Date TASK A Pros and Cons of Financial Reporting Regulation 1. Introduction This paper seeks to critically discuss the arguments for and against the regulation of financial reporting, citing relevant academic literature in support. This in the context of the observation that financial reporting is arguably one of the most heavily regulated areas of business activity yet commenters and interest groups have called for more of the same after the latter blame laxities in the regulatory framework of financial reporting from the recent high profile corporate collapses and misdemeanours . 2. Arguments for regulation 2.1 Higher liquidity with the view of lower cost of capital Financial reporting regulation is normally about mandatory disclosure and compliance requires use of resources. Necessarily there is cost of regulation brought by need to have increased filing and making available to the public information about the business. Although, it is assumed that in every cost there is an expected advantage, it is decision that is not only easy to make especially when one is compelled to do it. In the same way that human beings need to have laws to maintain order, the business community need some guidelines in the way they make their responsibilities discharged to the public. Higher liquidity comes with the help given to decision makers so that they can make informed decisions without speculating on whether on what they get is as good as other decision makers would get. Public Corporations do have their stocks listed and sold at the capital market and they required to file financial statements with the regulatory agencies for the purpose of disclosing to the investing public their financial operation. With relevant information coming from disclosure, buyers and sellers would be more ready to make decision in the capital market. The expected benefits from liquidity would include reduced cost of capital. The lower the cost of capital the better it is for the business. The lower the cost of capital, the lower is the cost of doing of business. 2.2 Guidance for decision makers and prevention of adverse selection with the view of lower cost of capital The consequences of adverse selection by lack or information or what is called as information asymmetries among investors (Francis, Olsson, and Schipper, 2008). Some investors who will lack information or are less information would be at a disadvantage compared with better informed or privately informed investors. This is the essence of insider trading and this could contradict the essence of an effectively working capital market where information is free to all investors in equal footing for market to really function theoretically. As such, one who has no or little information would be technically facing a greater risk at least from their minds and they would value investment options of risk aversion by perhaps undervaluing the same to compensate them for the added risk of uncertainty. Thus, there would be what is called as "bid-ask spread” (Brigham and Houston, 2011) in secondary share markets as a result of price adjustment available to traders who have better information. It is also not far to think that if traders lack information and there is adverse selection that the number of traded shares would not be as what the market should allow. The reduced demand of shares when translated economically would of course result to low liquidity in the stock market which is actually flexibility in buying and selling shares of stock with low cost and not much affected by little price adjustments. One of the requirements financial reporting is the requirement of disclosure. This would have the effect of mitigating so called adverse selection by investors as the latter would have more information in making decision. Investors can freely get them from available resources including those of regulators. This increased information should redound logically to better liquidity as investors would have flexibility in buying and selling shares of stock given the fact there is little price adjustment with the assumption that not one investor of group of investors would be fortunate enough to have a private information that he or it could take advantage in trading shares in the market. Regulation essentially promotes then providing more information to the public domain with the effect of minimizing investors who would be privately more informed than others. This is the basic principle of economics where buyers and sellers have access to free information for purposes of making decisions in the market. . 2.3 Proper regulation is necessary in Corporate Governance Financial reporting regulation is necessity in corporate governance and corporate governance is required by as in Sarbanes-Oxley Act (SOX) in 2002. Regulation is the solution for imperfect market causing serious market failures. These are the so called externalities which cannot be solved by the allowing free market forces in the economy. The SOX of 2002 came into being to prevent repetition of scandals by fraud committed by companies. This is the so called externality that can only be addressed by regulation. It was designed for the protection of investors through improvement in the accuracy and reliability of disclosures by corporation on securities (DeVay, 2006). It is therefore clear that the need for regulation necessary when scandals and corporate collapses happen that could render the government helpless. When companies can make false financial reports due to absence of standards how should reporting be done, the effect could only be to mislead rather than properly informed investors as decision makers. However, there should be moderation in everything as the tendency to overregulate ay happen and the same could really a problem for business. 3. Argument against - Cost of Regulation could be prohibitive There are direct costs and indirect costs of regulation. Financial reporting requirements are necessarily producing more cost to business entities. It is not difficult to that more requirements mean more preparation for companies as they comply with regulators. It would also mean more certification and dissemination of accounting reports. More of these simply means substantial cost ( Ribstein, 2005) as there is opportunity costs involved for those who are making disclosures to the public. Companies need to tell about their products and their plans to the buying and investing public and this they could actually do by voluntary disclosure. These companies could not expect to raise good prices for their shares if they would not do at least some advertising. However, the issue in financial reporting is aside from what is voluntary disclosure there is also the mandatory ones. If regulators would make such mandatory ones, it could also be punishing the small companies who may not be able financial or technically to comply with regulatory requirements. More stringent requirements should translate to hiring better professionals and essentially this would be creating more cost to small investors, which, technically, is creating economies of scale for those bigger companies which could afford the higher disclosure costs. This action of regulation if abetted by government would contradict one of the purposes of promoting free market for industry players. Why make such a government regulation a basis for destroying or restricting good competition? Mandatory disclosure creates indirect cost also to capital market participants. This would have the effect of allowing other parties like labour union, competitors, tax authorities and regulators to use the mandatory information. To force company to provide information about the profitability of line of business is to encourage competitors through revealing proprietary information to come in that line of business and lure tax authorities to come in also into the picture. The labour groups would also be more interested in pursuing their demand for better salaries and benefits as a result of better profitability. Mandatory disclosure could actually discourage business entities and they have no freedom to protect their trade secret, they would not be in a better position to at least maintain their profitability that could sustain the viability of the business. Decision makers are however not easily duped to those that are not making disclosure since they are still to make decision even without the complete information. Thus, responsible corporations can actually take advantage making information available to the public as they could actually tell that there is overproduction in an industry and this could discourage new entrants. The rule then should be in being candid to what is beneficial to the public as the latter is an essential part of the business in accordance with the principle of corporate governance. The desired objective of regulation which is to reduce of capital my promoting liquidity or reducing liquidity risk could necessarily result in reverse and could increase cost of capital instead. 4. Conclusion Argument for having regulation proved better than having none at all. Although there is self-regulation where market forces are allowed completely, the same cannot fully addressed the externalities without effective and proper regulation in financial reporting. The reality of corporate governance is well accepted and as long as government exist, regulation can never be completely disregarded. Not all investors or decisions makers are similarly situated. Financial reporting may actually be levelling the playing field but overdoing the same could actually do the reverse if an economy of scale is created for bigger companies at the disadvantages of those who should be protected most. Continued research should be done to balance acts of regulation in accordance with the need of the times. References: Brigham and Houston (2011) Fundamentals of Financial Management, Concise Edition. Cengage Learning DeVay, D. (2006). The Effectiveness of the Sarbanes-Oxley Act of 2002 in Preventing and Detecting Fraud in Financial Statements. Universal-Publisher Francis,F. Olsson,P. and Schipper, K (2008). Earnings Quality. Now Publishers Ribstein, L., 2005. Sarbanes-Oxley after Three Years. University of Illinois Law & Economics Research Paper. PART B A Comparative Financial Statement Analysis Report of WM Morisson and Tesco 1. Introduction This paper seeks to prepare a comparative financial statement analysis report for WM Morisson (or “Morisson”) and Tesco for the year ended 2013 using a detailed valuation on the following ratios: profitability, financial management, gearing and investment ratios. The analysis will show inferences for each of each of the four groups of ratios mentioned above and will take into account the viewpoints of all corporate stakeholders. 2. Executive Summary of two companies and their industries Both Morrison and Tesco are from the retail industry and they are deemed to more or less affect by the same industry opportunities and industry threats. However a company may be not assumed a good as the other when it comes to reacting to the same industry opportunities and threats in the same way that each has its own priority in generating value for their shareholders. By investigating their financial statements through the use of their financial ratios in relation to other competitors in the retail industry, this investigator would have an objective view of which is better in managing each company‘s resources in relation to their wealth defined objectives in relation to external and external environment with which they operate. 3.1 Brief Company Background of Morisson WM Morisson Supermarkets PLC operates in Britain as a food retailer. As of January 2012, the Company is reported to have about a 500 stores across Britain, in different sizes to as low as 3,000 square feet for the smaller ones and to over 40,000 square feet for the bigger ones. It operates with its subsidiaries which engaged in various business including manufacturing and distributor of food products, a meat processing. It has also Safeway Limited, as one of its subsidiaries, which operates as holding company, and Optimization Developments delivers goods and services for its property development (Reuters, 2014a) It continued to expand every year as evidenced by opening more than 35 stores for the year ended January 2012. It continuous also to make acquisitions, including its purchase of Flower World Limited. As the acquired company was engaged in a wholesale flower business, the same would show is strategy of vertical integration (WM Morisson, 2014) as way of expanding its business and ensuring better quality for customers. Acquisition in 2011 include that of a multi-channel by the name of kiddiecare.com Limited (Kiddicare) 10% share in Fresh Direct (Reuters, 2014a). 3.2 Brief Company Background of Tesco As contrasted with Morisson, which operates only in Britain, Tesco PLC as an international retailer, has a wider customer base. No wonder it’s the total amount of its total assets in 2013 is more than four times that of Morisson. The company’s retailing business and associated activities are felt and witnessed in the United Kingdom, the Republic of Ireland, the United States, Slovakia, South Korea, India, Malaysia, Thailand and Turkey. Its retail banking and insurance services is also felt via, Tesco Bank as its subsidiary. Inside its stores are varied services including that of optician, phone shop, and pharmacy or customer restaurant. With over 180 opticians as of February 2012, the company’s operation could only be viewed big in size. It makes its customers happy via its multi-channel offering, store and distribution networks as the latter are allowed the opportunity to pick products over more than 750 stores, in relation to their place of work or residence. (Reuters, 2014b) 4. Ratios for Analysis The different ratios for analysis are different ways to analysing how the companies differ to each other and in relation to in their performance within the retail industry. Each set or group of ratio is explained and their significance is discussed in relation to the wealth maximization and other objectives of the two companies. Wealth maximization objective is an undeniable objective for companies since they are owned by shareholders who put their resources and investment not for the sake of having just something to do but for the purpose of maximizing wealth (Higgins, 2007). There is an opportunity cost for money and resources and nobody would generally want to lose money. Each is assumed to expect a return or value from investment made and after sometime or a certain period of time, one is expected to better off. 4.1 Profitability Profitability ratios tell a company’s ability to earn a satisfactory return on sales, total assets, and invested capital (Helfert, 2011). However what is satisfactory to one may not be satisfactory to others. Profitability is basically measured by having an excess of revenues over cost and expenses of doing business. From an accounting viewpoint, there is an increased book value of investments over time and from period to period or year to year, there is need to record the incremental profit (Johnson, et al, 2003). Thus in computing profitability the revenue value is the divisor and numerator may either be the net income, net operating income and the gross income. Table A below would start best the discussion of profitability ratios, which include the, net profit margin, operating margin and gross margin. Table A: Summary of Financial Ratios (Tesco, 2014; WM Morisson, 2014, Reuters, 2014c) It would not be an all-encompassing statement to say that a company earning a 4% return on sales or net profit margin is superior to another company earning a 0% if the same ratio is supported with other related ratios of the companies. This may appear as the initial picture of Morisson and Tesco with first having the higher rate and the second company with the lower rate. By investigating the gross margin of two companies, Morrison reflected 7% while Tesco averaged 2% for the 2013. The higher profitability of Morrison is validated by having higher operating margin where it exhibited 5% as against Tescos 3%. See Table A below together with Appendices A and B for the formula and summary of extracted data from the financial statements of the two companies. Between Morisson and Tesco, the former has lower margin in three profitability ratios. Both companys net profit margin and gross margin are also below industry averages. The lower profitability of the former is not however final as the same could still compared in other ratios. Companies’ performance ratios tell how they delivered well to their stakeholders in the same way that a doctor’s checkup results would tell health of a person at a certain point time. Gross profit margin which relate to gross income to sales tells on how much can the retail companies can get from selling the products and services by comparing the selling price and the cost of the product. It may be pointed out that both companies have below 10% gross margin but the rest of competitors are having above 35 %. This would indicate wide latitude where companies could actually become more profitable. This was not however observed in the relationships with net profit margins and net operating margins of the two companies in relation to the industry, where differences were only slight. 4.2. Financial management ratios Financial management ratios basically refer to ratios how a financial manager evaluates financial performance of a company. Said ratios can include profitability, liquidity, solvency and valuation ratios. Since profitability was discussed first, this section would deal more on liquidity ratios. Solvency and valuation ratios would be discussed in succeeding sections. Every company needs to have good liquidity ratios to indicate is capacity to pay current obligations. Such ability to meet such currently maturing obligations is demanded from management of company or they could be considered to be near or going into bankruptcy which is bad for said investors. Good liquidity is similar to having a well-conditioned office which can assure the office owner lack of trouble with a short period of time. A liquid company pays timely salaries of its employees, accounts payable with outside suppliers who keep on delivering goods to put in the shelves of the stores and supermarkets and other accrued expenses are settled at the right time so that they could also conduct their activities in a regular manner. Do Morrison and Tesco have these characteristics? Morissons latest current ratio at 0.57 was lower than Tesco with 0.66. Both ratios are below the industry average of 1.02. The same could be said in terms of the quick assets ratios, where Morisson exhibited 0.20 while Tesco showed 0.43. Both ratios again are below industry average. The meaning then of having profitability ratios lower than industry average would be interesting for evaluators. Would the ratios tell that they can survive in the short-term? The answer of course may still be in affirmative considering that the company‘s current ratio is not very far from 1.0 level. If they fail, the consequences could be bankruptcy and possibly it could cause either company to stop doing business and let creditors take money and resources (Helfert, 2011). Considering also that they are in the retail industry where goods are easily converted to cash, their liquidity could not be a serious problem still. 4.3 Gearing Gearing ratio is similar to solvency which measures the financial leverage of companies by demonstrating the degree of how the company is financed from shareholder as against creditors (Higgins, 2007). Companies need assets to run the business in producing profits which are partly financed by shareholders and creditors. Companies do need to borrow in additional to investment made by stockholders. As legal entities working through the board of directors and shareholders, such companies incurs debt or loan agreement to have more assets to be used in business. Said increased assets are need to finance the growth the company in terms of revenues which must increase every year as normal part of business. No borrowing means not maximizing the value generation by the company. Thus corporations do generally chooses borrowing to maximize value generation since capital generated from debts could entitle the company for deductibility of interest expenses from these debts for tax purposes. However, borrowing by companies cannot be assumed unlimited and this could increase the risk of bankruptcy in case of slowdown in the expected revenues. An indicator to provide a benchmark on how should the company limit its borrowings or debts from creditors is answer by this ratio. The balance can generate the so called debt to equity ratio computed by dividing total liabilities with the total equity of the corporation. In getting the ratios of the two companies, the same can be taken from their total liabilities and total equity per year for three years. Morisson reflected debt to equity ratio for 2013 of 1.01 as against Morisson at 2.01. Both the said ratios are higher than the industry average of 1.02. This means the two companies are better leverage compared with competitors. Note that the higher the ratio, the higher is the leverage. But since the two companies appear to have survived the financial crisis of in the past years, their continuing into a business is an indication of their capacity to withstand temporary financial tsunamis that may occur from time to time as economic factors change in the environment. Given the better gearing ratios of two companies in relation to the industry, their lower-than-1.0 level of liquidity as discussed and justified earlier could be remedied in case they encounter some liquidity problem. They may pledge some of their assets for some cash to make their operations liquid and avoid short-term insolvency. 4.4 Investment ratios The investors’ response to the companies involved can be checked from the investment or valuations ratios in terms of price-earnings ratio, price to sales, price to book ratio, price to tangible boo and even price to cash flow as shown in Table B below. However due to more risky position of Tesco than Morisson, the same explain its higher beta. In terms of P/E ratio for the last twelve months Tesco reflected higher ratio. This means that despite lower profitability of Tesco, investor could assume a higher risk with Tesco over that of Morisson. The same is evident even that for the last five years. Even on price to sales, price to book ratio, price to tangible boo and even price to cash flow, Tesco reflected higher which explains its higher beta. Since both below to same industry, yet investors are taking higher risk. They are assuming that over the long-term they could maximize their earnings more with Tesco rather than with Morisson. This is the significance of looking at more years to validate the analysis while this paper has mainly focused for latest year. But statistics would show that Tesco was better for the last five years in terms of profitability (Reuters, 2014c). In terms of total assets, Tesco four times bigger than Morisson. Table B- Comparative Investment Ratios (Reuters, 2014c) 5. Conclusion This paper has found profit maximization strategies employed by Morrison to be better than that of Tesco on the average for year 2013. Morisson has however shown lower liquidity as against Tesco and its other competitors in the industry. It has also lower financial leverage compared with Tesco. Morisson may be declared to have outperformed Tesco in terms of profitability. However with wealth generation as measured by valuation ratios, Tesco reflected higher which means that investors can take a higher risk with the company. Morisson’s secrets in arriving with better results profitability and liquidity would indicate in being able to identify opportunities for profitability as it responded to the changing needs of its customer. It has lowered its prices and introduced affordable products and made more promotions. Although it appears that between Morisson and Tesco, the former is better than the former in terms of profitability and financial management ratios, the higher gearing ratios and better investment ratios of the latter raises a question as to weight of relevance of ratios. Compared however with rest of competitors in the industry the two are not better when it comes to price-earnings ratios. The higher ratios of the industry point to the non-maximized wealth-generation potential of the two companies. But between two of them Tesco is definitely better. From the point of investors, there is basis to invest with the company. By doing business outside UK compared with Morisson, the Tesco may have taken more the opportunities and has managed its risk better. By so having higher financial leverage given its lower profitability ratios was less relevant to investors as they reacted to by investors by having higher prices in relation to earnings, Tesco can be chosen as the better company for purposes of making an investment From the point view of management, there is basis to conclude that there are still rooms for improvement and that the need to improve the level of performance is paramount given the wealth maximization objectives of both companies. The relationship of the four group of ratios used in this can be summarized as follows: Business entities need to be profitable to higher an acceptable level of liquidity. But of these two cannot be pushed unnecessarily as it could result to higher risk as would be measure in gearing ratios. The more relevant evaluator still is the valuation or investment ratios since it reflects the current behaviour of investors as measured in terms of price-earnings ratio. Appendices: References: Helfert, E. (2011). Techniques of Financial Analysis: A Mode. McGraw-Hill Education (India) Pvt Limited Higgins (2007) Analysis for Financial Management, Eighth Edition. Front Matter Quick Reference URL Guide. he McGraw−Hill Companies Johnson, et al (2003). Financial Accounting. Tata McGraw-Hill Reuters (2014a). WM Morisson Company Profile. Retrieved January 31, 2014 from Reuters (2014b). Tesco Company Profile. Retrieved January 31, 2014 from http://www.reuters.com/finance/stocks/companyProfile?symbol=TSCO.L > Reuters (2014c). Industry Ratios. Retrieved January 31, 2014 from < http://www.reuters.com/finance/stocks/financialHighlights?symbol=MRW.L> Tesco (2014) 2013 Annual Report. Retrieved January 31, 2014 from < http://files.the-group.net/library/tesco/annualreport2013/pdfs/tesco_annual_report_2013.pdf > WM Morisson (2014). 2012/2013 Annual Report. Retrieved January 31, 2014 from < http://www.morrisons-corporate.com/Documents/Annual-Review-2012-13.pdf > Read More