The Economic Implications of Corporate Financial Reporting - Literature review Example

Financial reporting Introduction Accounting is defined as the process of recording, ifying, analysing and summarising financial transactions fora specific time period, which are further presented to various stakeholders in the form of financial reports. The primary idea behind financial accounting is to deliver information that is useful in various economic decisions that are of financial nature. There are a number of internal and external groups who require different financial information for decision making. Most information is presented in the form of income statement, balance sheet and cash flow statement. A semi-structured list of financial information users includes bankers, existing and potential stockholders, financial analysts, bondholders, customers, tax and other regulatory authorities, suppliers and employees (Revsine, et al., 2005). Importance of financial reporting in terms of utility is a relatively broad concept and requires consideration of various aspects including its users. In this paper, wide information needs of different users have been evaluated critically so that relationship between information need and objectives of different users is understood. However, financial reporting is developed based on certain financial assumptions which in turn, result in discrepancies in the disclosure of different financial information. The paper discusses various limitation of financial reporting which need to be addressed besides discussing about various users of financial reports and their informational needs (Graham, Harvey and Rajgopal, 2005). Users of financial statements The principal purpose of financial statements is to provide information seekers adequate data regarding various economic entities which will help them to make decision in the light of complete knowledge regarding the entity and its activities (Holthausen, 2009). According to many authors, the most important objective of financial statements should be delivering relatively vast and more comprehensive information that are generally offered in balance sheet, income statement, change in equity statement and explanatory notes. Initially, managers were identified as the main users of financial information (Sabău, 2013). Consequently, authors such as Edwards and Bell (1964) proposed that, the primary function of accounting should be providing management with relevant information necessary for assessment of activities such as measurement of operating profit and accumulated earning. The authors further added that, accounting information helps in decision evaluation and thereby, contributes towards resource monitoring, better decision formulation and implementation. In the viewpoint of Edwards and Bell (1964), tax authorities, analysts, business owners and other stakeholders should largely be considered in a group that has significant influence on the information produced. Alongside, they negated role of external users of financial information in business decision making. Contrastingly, Sterling (1979) classified various users among managers and stakeholders; where stakeholders comprise creditors, employees, suppliers, government entities and others. In the United Kingdom, the Accounting Standards Steering Committee published ‘the Corporate Report’ in 1975 which identified and listed various users of financial statements (Sabău, 2013). Group of investors: Share and securities holders Creditors: existing and potential bond holders and short term and long term secured and unsecured loan providers Employees: Former, existing and prospective employees Group of analysts and advisors: Economists, researchers, financial analysts, statisticians and other advisory service providers. Business partners: Competitors interest in merger and acquisition, customers and suppliers. State authorities: tax authorities, local authorities and other entities responsible for oversight of trade and commerce. General public: tax payers, political parties and consumer rights protection organisations (Young, 2006; Sabău, 2013). Information needs of various user groups Different groups of stakeholders require separate set of information from financial statements but these stakeholders can be interrelated in terms of their role in an organisation and their purpose: Among most important stakeholders, equity investors and partners of a firm included. Equity investors and partners are also member of an organisation’s board and they take in consideration two primary factors associated with investment, namely, income and gain. Income is generally reflected in the form of dividend, while gain in the form of appreciation in the share price. However, they are also interested in firm’s long term viability as they evaluate a firm’s current performance and profitability trends using the reports so as to determine prospects of future investment. Besides firm’s partners and other shareholders, employees are also considered as primary stakeholders of a firm. Employees are an important intangible asset of a company and take significant part in organisational development from monetary and non-monetary perspective. The employees require information regarding financial performance of the company because of two reasons- salary and wage negotiation and assessment of their present and future opportunities in the organisation in terms of employment. Through financial reports, employees primarily evaluate a firm’s long term and short term financial stability and viability. Additionally, the financial statements are a source of understanding and communicating organisational activities in monetary terms for managers among various departments. While employees and partners are generally considered as internal stakeholders, various creditors, suppliers, government organisations and existing and potential consumers are considered as external stakeholders of a firm. Various short term and long term lenders are generally referred to as creditors. Creditors generally have direct interaction with various middle level managers of different departments such as purchase, production and inventory management. The main concern of creditors regarding an organisation is, whether they will be able to recover the amount that they have invested in the firm in the form of short term loans. Generally, short term creditors evaluate cash flow statement and income statement of a firm so as to determine if the concerning firm is generating sufficient earnings to cover its debts. Medium and long term creditors generally evaluate growth prospects and future profitability of the firm. Creditors are provider of capital and they depend significantly on financial condition of a firm for the profitability and safety of investment. Consequently, they expect steady financial performance on behalf of the firm (Benjamin and Stanga, 1977). In context of creditors, Suppliers are considered as short term trade creditors of a firm and have significant contribution towards working capital of the organisation in the form of supply. Suppliers are generally interest in short term financial stability of a firm and evaluate firm’s inventory management and sales figures. Suppliers are considered as current liabilities of a firm, and they take in consideration a firm’s overall cash flow so as to ensure that the party does not turn insolvent. Suppliers use financial statements such as balance sheet and income statement for financial analysis through creditor turnover period and velocity to access scope of the firm’s to be insolvent. Besides suppliers and creditors, consumers are also included among external stakeholders as they have significant contribution towards a firm’s revenue. Potential and existing consumers are invariably a significant asset for a firm and Customers are interested in financial viability of a firm because they want continuous flow of high quality goods and services in long run. Alongside, long term consumers are also interested in environmental policies of a business as well. Presently, consumers not only buy good quality products but are also equally interested in the eco-friendliness of the processes firm is employing and its direct and indirect contributions towards the society. Consequently, they show significant interest in the firm’s annual report. A firm’s interest and investment in corporate social responsibility is reflected in its annual reports which again helps the firm to acquire greater consumers in a market. According to Frank, Lynch and Rego (2009), another important stakeholder of a firm is the local and national government. Various government authorities such as taxation and revenue department require financial information of organisations so as to determine credibility of the firm in terms of tax return fillings. Other regulatory authorities such as consumer rights protection organisation require financial information of a firm for protecting investors and other stakeholders from fraudulent activities (Beasley, et al., 2000). It is noteworthy that every private and public organisation is liable for pursuing certain government regulations in context of their business. For instance, generally no firm is allowed to undertake unscrupulous fund raising or resource extraction. Additionally, certain organisations such as manufacturing concerns need to take permission from specific government authorities, namely, pollution board for their operations. All these details should be included in annual reports directly or indirectly in the form of explanatory notes (Frank, Lynch and Rego, 2009). Lastly, every organisation has certain responsibility towards the society as the society as a whole is the primary source of a firm’s earnings. General public can take interest in a firm’s financial condition so as to determine the contribution of the firm towards societal development. A clear disclosure of all relevant information helps in enhancing goodwill of a firm (Benjamin and Stanga, 1977). Conclusion Financial reporting is considered as an essential part of an organisation’s activity. Financial reports such as balance sheet and income statement ensures that the company has sufficient record of its activities in monetary terms. Another importance of financial reporting is that, it enables various internal and external stakeholders of the firms to have update information regarding the financial position of the firm. In this paper, detailed assessment have been done regarding various users of financial statements as well as information needs of various users have also been discussed. Overall it was observed that stakeholders’ interest in a firm’s performance indirectly helps a firm to grow. Reference list Beasley, M. S., Carcello, J. V., Hermanson, D. R., and Lapides, P. D., 2000. Fraudulent financial reporting: Consideration of industry traits and corporate governance mechanisms. Accounting Horizons, 14(4), pp. 441-454. Benjamin, J. J. and Stanga, K. G., 1977. Differences in disclosure needs of major users of financial statements. Accounting and Business Research, 7(27), pp. 187-192. Edwards, E. O., and Bell, P. W., 1964. The theory and measurement of business income. California: University of California Press. Frank, M. M., Lynch, L. J., and Rego, S. O., 2009. Tax reporting aggressiveness and its relation to aggressive financial reporting. The Accounting Review, 84(2), pp. 467-496. Graham, J. R., Harvey, C. R. and Rajgopal, S., 2005. The economic implications of corporate financial reporting. Journal of accounting and economics, 40(1), pp. 3-73. Holthausen, R. W., 2009. Accounting standards, financial reporting outcomes, and enforcement. Journal of Accounting Research, 47(2), pp. 447-458. Revsine, L., Collins, D. W., Johnson, W. B., Collins, D. W. and Johnson, W. B., 2005. Financial reporting & analysis. New York, NY: Pearson/Prentice Hall. Sabău, L.I., 2013. Information needs of financial statements users- between harmony and conflict. West University of Timișoara. [pdf] Available at: [Accessed 24 October 2014]. Sterling, R. R., 1979. Theory of the measurement of enterprise income. Kansas: University of Kansas. Young, J. J., 2006. Making up users. Accounting, Organizations and Society, 31(6), pp. 579-600. Bibliography Carcello, J. V., and Nagy, A. L., 2004. Audit firm tenure and fraudulent financial reporting. Auditing: A Journal of Practice & Theory, 23(2), pp. 55-69. Elsayed, M., 2012. Issues in financial reporting. Australia: McGraw-Hill. Read More