Avoiding Losses in Reporting, Meeting Expectations of the Investors and Stakeholders - Research Proposal Example

Finance and Accounting The research proposal highlights impact generated by reporting of non-recurring items in financial ment of companies. There are different ways of reporting items in the financial statement. The procedure for presenting items is specified by different accounting standards. These rules and regulations of accounting standards vary country wise. The presentation and reporting of financial statements should comply with rules and regulation of the country based accounting standard. If such is not maintained, then during audit programs, companies might face legal issues, which can even lead to worse situations. So, proper representation and reporting of financial statement is imperative for all companies since finance is a vital segment in any industry, which drives the whole business. There are many items in the financial statements, which are essential for reporting. Non-recurring items are those, which carry equal importance as that of others, yet certain standards ignore these due to various reasons. The research proposal highlights impact of reporting non-recurring items under International Accounting Standards (IAS). It is observed that under IASB and FASB, reporting of non-recurring items is not encouraged due to various reasons. A literature review pertaining to the topic is made by foregrounding presentation of non-recurring items and its impact. Research questions are developed in order to understand and recognize influence of non-recurring items reporting under IAS 1 on investor decision. The methodology discusses ways to validate the research questions. Table of Contents Abstract 2 Introduction 4 Literature Review 5 Research questions 6 Methodology 7 Importance of study 9 Conclusion 10 Reference list 11 Introduction Financial statements are vital for a company since it reflects the financial condition. Every company hires efficient accountants who can prepare the statements without committing any mistakes (International Accounting Standards Board, 2008). There are few financial items, which comprise transaction of companies, but are not mentioned in financial statements. The reason behind eliminating these transactions from the financial statement has been portrayed differently by IASB and FASB. According IASB, the reason for not mentioning non-recurring items in the financial statement is that there is a notion of infrequent or unusual events or transactions in IFRS, which are not worth mentioning. However, “FASB is of the opinion that each of entity in the financial statement should be disclosed so as to improve the understanding of the users which relates to the components which are less persistent and more subjective than the rest of the components in that line” (International Accounting Standards Board, 2008). So, FASB has advocated that non-recurring items are not essential for the users to understand and recognize since these do not form the main line of items in financial statements. It is observed through several surveys in United States and United Kingdom that confronting expectations of investors and fulfilling them is the main earnings target for all companies. In the past, there was severe reaction in the stock market, which was caused due to negative earnings of companies. Nonetheless, it is also evident that a stock market is rewarded by the positive earnings. It motivates companies to provide managers with strong incentives in order to analyze the earnings forecasts appropriately, thereby augmenting company’s profitability. This also helps companies to be aligned with the stock market performance and to use their wise judgment over the reported earnings to fulfil expectations of stakeholders. This research proposal gives emphasis upon whether or not the UK firms are able to employ earnings management for meeting expectations of investors. The proposal also highlights accrual management that is used to examine the earnings management procedure (Finnair, 2006). The managers exclude non-recurring items from core earnings of the company. It is observed that companies at times engage in classifying the recurring expenses or losses for inflating core earnings and meeting expectations of the investors. Such practices are often adopted by the UK firms. Literature Review The literature Review aims at disclosing concepts and views of different authors regarding the earning management. It also highlights the fact whether companies perform honest disclosure of each and every item in the financial statement. Many companies have been noticed in recent years to emphasize upon Generally Accepted Accounting Principles (GAAP) adjusted earnings during their quarterly press releases. Graham, Harvey and Rajgopal (2005) in their survey regarding the chief financial officers of United Kingdom had identified that expectations of investors and proper earning management are the most important responsibilities of managers of a company. The strong stock market reactions to small negative earnings basically surprise investors, treating the situation as a missed target, which signals considerable decline in underlying performance of the company share. However, investors view positive earnings as a confidence booster as it reflects that the firm is well managed, predictable and can deliver good future earnings. Skinner and Sloan (2002 cited in Anderson, Banker and Janakiraman, 2003) and Brown (2003 cited in Anderson, Banker and Janakiraman, 2003) documented adverse reaction of market on the earnings, which fail to meet expectations of investors and market as a whole. Kasznik and McNichols (2002 cited in Anderson, Banker and Janakiraman, 2003) found out that companies that satisfy investors’ expectations is adequately rewarded by the market. The reward is associated positively with future performance of the company. Doyle, et al. (2006 cited in Anderson, Banker and Janakiraman, 2003) showed that market reward is effective in guarding against risk factors that are prevalent in the market. It also helps in removing market anomalies, which affects the variation in return. The earnings management is one of the most important subject matter of academic researches of all time. The evidences against managers highlight that accrual manipulation that is involved in the earnings are of different patterns. The manner in which accounts can be manipulated is by way of real activities management, which includes discounts for increasing sales, lower discretionary expenditures assigned for advertising and research and development as well as accumulation of inventory for reducing cost of goods sold. This type of manipulation involves string accounting fraud, which is accompanied by litigation risk for major firms and also employment risk for managers. Even so, it is evident that real activities manipulation does not breach GAAP, but sacrifices future economic benefits of the company. McVay (2006) had pointed out another type of earning management. She had assessed whether managers have manipulated core earnings by classifying the operating expenses as special items. It was found that managers can forge transactions to such an extent that investors fixate on core earnings, instead of trusting the GAAP. The managers can employ classifications as the way of fooling investors by manipulating the earnings. Research questions The main research aim is to examine whether or not it is appropriate to report loss of a company in the financial statement in terms of non-recurring items. In order to reach this goal, research questions are formulated, which will direct the whole research process and generate hypotheses accordingly. The research questions are mentioned below. 1) Is it correct for IASB and FASB to decide against reporting non-recurring items in the financial statements? 2) Do UK investors trade on earnings before non- recurring items? 3) Do companies mislead investors by disclosing the earning before non-recurring items? The hypothesis developed as follows: H1: Avoid the losses in reporting H2: Avoid disclosing reporting of decline in earnings. H3: Meet expectations of the investors and stakeholders. H4: Affect perception of the investors before offering of equity. H5: Affect perception of the debtors before offering of debt. The hypothesis, thus, developed highlights on overall performance of the earning management and its relation to investor knowledge. Proper earning management leads to increase in confidence of investors as well as stakeholders. The stakeholders here comprise employees, investors and the public as a whole. It has been examined whether expectations of stakeholders are met. Here, the expectation refers to the fact that investors demand for higher return from investment that they make in company equities. If there is proper earning management and disclosure of items in the financial statement, investors are assured that the company is not hiding any cost from them, inflating their profit. The actual profit of the company is very important for investors since they invest in equity shares only after analysing consistency of company profit. Methodology This section of the research proposal comprises main aspect of conducting the research. The methodology describes ways to analyze the research question and that of accepting or rejecting the hypotheses. In order to study research questions, dependent and independent variables are chosen accordingly. The variables are clearly defined so as to get a perfect idea of research questions. Data is collected from 30 UK companies for each quarter to derive exact results of the survey. Though the sample size is small, result obtained can be rendered effective by considering exact values from the financial statements of companies (Graham, Harvey and Rajgopal, 2005). The dependent variable is Core Earning (CE). There are number of independent variables, which are as follows: UE-CE = Unexpected Core earnings %Si = Special items as percentage of sales Accrualsq = Accruals as net income Returnq= Market adjusted return of three months corresponding to the fiscal quarter. ATOq = Asset Turnover ratio ∆ Salesq = Percentage change in sales The definition of the variables is as follows. Core earnings of a company is calculated as Sales minus the cost of goods sold minus administrative and general expenses in a particular quarter. Unexpected Core earnings are calculated as the reported earnings minus expected core earnings that are estimated by the industry during that particular quarter. %SIq is defined as the special items calculated as percentage of sales (Graham, Harvey and Rajgopal, 2005). The special items that reduce income level of the company are multiplied by -1 and vice versa. Accruals are calculated by net income before the extraordinary items minus cash generated from operation. Returns are calculated as the three months adjusted market returns relevant to the fiscal years. ATO or Asset Turnover Ratio is defined as Sales / ((NOAq + NOAq-1)/ 2). Here, NOA is referred to Net operating asset. It is defined as the operating assets minus the operating liabilities. Lastly, ∆ Salesq is defined as the percentage change in sales. It is calculated as (Salesq – Salesq-4)/ Salesq-4 (Graham, Harvey and Rajgopal, 2005). For evaluating core earnings of the firm, the following econometric model is used: Yi = α + β Xi After connecting the model and research aim of the project, the model can be written as: CEq = α0 + β1 CEq−4 + β2 CEq−1 + β 3 ATOq + β4 ACCRUALSq−4 + β5 Salesq This model is particularly used by McVay (2006). The main aim of expectations model of core earnings is to identify the relation between core earnings (CE) and performance of the company; hence, unexplained portion or unexpected core earnings are measured as the abnormal performance. The core earning of the last quarter is taken into consideration since it is closer to the current quarter of the next fiscal year (Anderson, Banker and Janakiraman, 2003). The ATO is inversely related to profit margins of the company. Nissim and Penman (2001) has defined core earnings to be closely parallel to profit margins. Sloan (1996 cited in Gu and Chen, 2004) identified that accrual levels can be referred as the explanatory variable for future performance of the company. The research does not consider the current period accruals. McVay (2006) has included percentage changes in sales (ΔSALES) and has allowed different slopes for the rises and falls in sales. McVay (2006) has included this because growth in sales relatively overshadows the fixed cost. The increase in cost is more when there is rise in activity, compared to the fall in activity when cost declines by the equal amount. Therefore, the methodology will highlight on outcomes of the research questions and figure out whether hypothesis will be rejected or accepted. The acceptance and rejection of hypothesis is dependent on the R-value of regression analysis. The regression analysis determines the fact whether reporting of non-recurring items is important for companies or not. Importance of study In this research, the main topic relates to reporting of the financial statement. It is very important for a company to publish its financial statement flawlessly so as to avoid any problem in the near future. It has been noticed that few companies following the rules of IASB do not publish non-recurring items in the statement and according to IFRS, such is incorrect. Nevertheless, there are different views regarding the same, given that it is the responsibility of accounting authorities to frame respective rules and regulation. Hence, it is essential to study whether or not it is correct to report non-recurring items. Conclusion It can be concluded that different accounting standards are responsible for introducing new rules and regulations. These rules are followed by companies in order to represent their financial statements. Hence, it is important to throw light upon the fact that accounting standards are majorly responsible for any type of chaos pertaining to presentation of statements. The exclusion of certain items in financial statements can lead to major problems for companies as investors are able to identify that the latter is not transparent in way of disclosing the major transactions. The items basically relate to transactions that are incurred by a company during a certain fiscal year. Reference list Anderson, M., Banker, R. and Janakiraman, S., 2003. Are selling, general, and administrative costs “sticky”? Journal of Accounting Research, 41(1), pp. 47–63. Finnair, 2006. Effects of the Transition to IFRS Reporting Standards. [pdf] Finnair. Available at: [Accessed 17 May 2014]. Graham, J. R., Harvey, C. R. and Rajgopal, S., 2005. The economic implications of corporate financial reporting. Journal of Accounting and Economics, 40(3), pp. 3–73. Gu, Z. and Chen,T., 2004. Analysts’ treatment of nonrecurring items in street earnings. Journal of Accounting and Economics, 38, pp. 129–170. International Accounting Standards Board, 2008. Preliminary Views on Financial Statement Presentation. [pdf] International Accounting Standards Board. Available at: [Accessed 17 May 2014]. McVay, S. 2006. Earnings management using classification shifting: An examination of core earnings and special items. The Accounting Review, pp. 501–531. Nissim, D., and S. Penman. 2001. Ratio analysis and equity evaluation: From research to practice. Review of Accounting Studies, 6(1), pp. 109–154. Read More