Social and Environmental Disclosure - Essay Example

An Evaluation of the Usefulness of Narrative Reporting In Financial Accounting Name Instructors Name Course Title Date Table of Contents Abstract 2 Introduction 3 Integrity of Narratives In Reports 4 Benefits of Financial Disclosures 6 Measurement of Quality of Narratives 7 Trends in Narrative Reporting 8 The Future of Narrative Reporting 11 Factors Affecting Narrative Reporting 12 Determinants of Narrative Reporting 13 Conclusion 14 References 15 Abstract This document critically evaluates the usefulness of narratives included in financial reports. It seeks to indicate the impact that these narratives have on stakeholders and to determine the measurement of their efficiency. The recent financial depression has necessitated the evaluation of all component of financial report to assess the influence they have on investor decision. Introduction Campbell and Slack (2008), define narratives as the non-financial parts of the reports included without legal obligation. A firm may disclose information to uninformed investors regardless of how good or bad the information is. Many disclosure choices are aimed at capturing and maintaining interest of shareholders, debt holders and management. The variance of the choices creates conflicts hence the provision of incentive which may also vary with company characteristics. Narrative reporting has the potential to enhance stakeholders understanding. To create this understanding, the shareholders are viewed as the chief addressees of the financial reports. This however does not mean ignoring legal compliance which is equally crucial. There is a struggle to balance the quality and quantity of information disclosed. Increase in the volume of reports has not increased the usefulness of reports. Analysts have indicated that these reports have become generic disclosure documents with unnecessary clutter. There is loss in purpose with the inclusion of lingual appealing jargons making narratives part of the problem and not the solution. This document seeks to evaluate the value that is attached to financial narratives and the implication that the narratives have on both the sell side and the buy side. The relevance of such narratives is sought out especially as pertaining to the shareholders and the organisational analysts. Recent corporate failures have necessitated evaluation of the significance of corporate disclosures. Narratives are now notably the only statutory formal communication between businesses and the external stakeholders. They provide an opportunity for the management to explain is objectives and strategies. They also provide a context for explaining the financial positions and performance of the entity. Integrity of Narratives In Reports The credibility of the reports is a matter of dispute as most parts of the narratives are edited to present the management is favourable light. This is in opposition to the social responsibility in that it is a conscious attempt to control the images that are real or imagined in social interactions. Bhana (2009) indicates that the narratives are useful as they help managers to report companies’ achievements and to mould the readers’ expectations on the reporting company. Poor performing companies have the opportunity to create a variance in corporation’s image with the overall reading of the report. Generally the management seeks to achieve positive image matching the expectation of the shareholders while avoiding negative values. In a study to determine the similarity in narrative content of poor performers and high performing companies, Bhana’s utilised reports of 50 listed companies with improved performance and 50 companies with declined performance. She determined that there existed great attempt to hide the negativity of the company. All company reports majored on the positivity of the fiscal year. It was also determined that words that signalled negativity were avoided in the reports thereby creating an effect that the company had a generally positive performance even if the fiscal year had significant losses (Bhana 2009). There is a feeling that narrative reporting is very important in making investment decisions (Eccles & Mavrinac 1995). With the concentration on positivity by the company managers, it is however misleading and creates a wrong impression of the company. This in totality obscures the intended purpose and usefulness of the report to the shareholders. With the current legislature not mandating audits on narratives, the trend of giving misleading information in the report will increase unless appropriate legislative measures are put in place. Of all the narratives reported the chairman’s statement was the most commonly read by shareholders. This gives the management the opportunity to give excuses for under performance and to manipulate the literature to positively influence investor decision. The use of narrative to enhance cooperation’s image is said to be a proactive management strategy. It is also a control and protective to the corporation when the image is threatened as a consequence of a predicament within the fiscal year (Gardner &Martinko 1988). The managers can use the narratives to admit fault or deny responsibility. These two uses are self-serving to the company. To effectively achieve this, the company varies linguistic construction with information from good to bad years being included. Language is used to blur the cause of poor performance. These variations in linguists are common for poor performance and are intended at creating a report that is generally complicated and difficult to read. The blurred attributions caused by lingual variations are a mechanism of hedonistic bias. There is a general trend to attribute everything positive to the company’s internal dispositional factors while attributing negatives with external environment. In addressing the issue of reliability of narrative reporting, focus is put on the ability of the report to provide sufficient information to users. The information in narratives should enable users to make an impartial decision regarding the future of the company. The disclosure should be ubiquitous of all dimensions of business operation (Beattie, McInnes, & Fearnley, 2004 112,115). It should offer reflective and potential decision inducing information. This is achieved if the report explains the resources used to drive the business in the specified direction. It should include the networks and the infrastructure available to achieve the business targets. The report may also include photographs which are only intended at distracting the reader. The use of graphs is aimed at enhancing the distortion of the readers’ perception. Graphs are constructed in such ways that they enhance good news while minimising the bad news. The Association of Chartered Certified Public Accountant (ACCA) (2011) reported that most business reports were low in quality especially in reporting the various elements of business that are poorly performed. This was so despite excellence in achieving retrospective information of governance, remuneration and the company’s financial position. ACCA recommend that reports have the inclusion of external audit and guidance from the International Accounting Standard Board (IASB). The future of narratives will therefore rely on the interdependence of stakeholders and regulators. Regulations should be enhanced by an unrestricted environment that accelerates brilliance through orientation towards shareholders requirements. Benefits of Financial Disclosures Benefits of disclosure are the transparency and accountability of the company’s management. It shows that the company has adopted an international compatible reporting framework. Disclosures increase the level of awareness among the stakeholders and improve communication practices of companies. The company will enjoy better brand equity and an improved image with greater market acceptance (Lang & Lundholm, 2000). In the social responsibility dimension, disclosures are a demonstration of social leadership and creation of social capital. Increased disclosure is beneficial to the capital markets in that the cost of capital is reduced. The companies also have increased liquidity and increased information intermediation. Withholding information causes suspicion by the investors. There arises doubt about the quality of investment and this may culminate in reduced investor interest in the company. Investor decisions are dependent on the adequacy of information about the company’s use of assets. Variations in the corporations reporting practices have dramatic effect on the resource allocation in international capital markets. Eccles & Mavrinac, (1995), noted that one way to get investors’ attention is to provide as much information as possible. The investors and analysts behaviour provides insight into the unobservable beliefs held. Measurement of Quality of Narratives The value of narratives can only be determined if methods of measurements of its quality are designed. Without standardised measurements standards, determination of the exact quality of information to users is difficult. Beattie, McInnes, & Fearnley (2004), introduce a four dimensional approach at quantifying the content of accounting narratives in financial report. She also contributes a much needed computer based methodology for content analysis and explores the complex concept of quality measurement. In the report they identify attributes of disclosure and suggest deputations for the same. Beattie, McInnes, & Fearnley, 2004 (p 114) critiques extant approaches to measurement of disclosures, such as the subjective ratings. Subjective ratings were intended to determine the quantity of information of disclosure. One main demerit was that they were based on analyst perception of disclosure and not the specific measure of the actual disclosure. The other extant method was the disclosure index studies which assumed that the amount of disclosure was directly related to its quality. This assumption was arrived at because of the difficulty in directly assessing disclosure quality. According to Financial Accounting Standards Board (FASB) (2011), the extensive nature of disclosure causes the necessity to minimise the sections used in analysis to three; the environment around the company, strategy and management, and internal environment of company. New ways would be advantageous in two ways, first is that they would be practical in benchmarking current accounting practices. In this way, inter company, inter industry and inter country comparisons could easily be made. Secondly, the new measurements would prove a better set of unbiased measures in relation to disclosures. This would authorise efficient tests of many researches as pertaining to narrative disclosures. Readability scores suffer numerous problems despite the objectivity and reliability of the disclosures. The readability scores focus on the sentence levels and ignore the aspects of texts as a whole. They fail to consider the interest and motivation of the reader. Lastly the levels of writing for children literature are deemed inappropriate for financial reports creating a need for higher level lingual presentation (Courtis, 1998 p351, 354). Trends in Narrative Reporting Surveys by ACCA (2011) have revealed that most company disclosures are of two types the, the risk reporting and business forecast reporting. Risk reporting involves the principle risks that a company faces in the daily operation. Despite the variance in risk types they all follow a similar reporting strategy. Reporting may consist of a qualitative description of the risks. These do not have any relationship with the financial statements but are more inclined to the organisational structure of the company. Companies in Europe and North America have more legal obligation to disclose non-financial risk information while those in Asian and Australian markets do not necessarily disclose these risks. The external risks disclosed included the political and economic risks and may even extend to regulatory and legal risks. Business forecasting provides forward looking information about the company. It is useful in gauging the profitability of the corporation. By giving forecasts the company gives the investors an idea of value creation and what is to be expected in the business. Despite the usefulness of business forecasts, legal requirements are not uniform in most developed countries. The disclosure is therefore not a mandatory requirement for companies. The extent of disclosure depends on the jurisdiction in which the company operates Vanstraelen, Zarzeski, & Robb, (2003). It is common in European company’s annual reports. Most other companies contain a similar section but fail to fulfil in totality the complete nature of a business forecast. This may only be forward looking information in the chairman’s statement and not within the body of the report. Vanstraelen, Zarzeski, & Robb, (2003) note that with obligated business forecasts, most European companies include verifiable third party information. These forecasts are made in relation to the country’s economic forecast and with extensive use of third party information. The forecasts are very detailed to the extent that almost every aspect of every department is captured in a forward looking position. This however appears bloated for shareholders who are content with only a few words from the chief executive. Relaxation of the legal requirements on disclosures will create more satisfactory narratives which are easy to measure and understand. Harmonisation will allow assessment of usefulness of nonfinancial disclosures and the effect they have on cross border listings. Transnationally focused companies tend to have more detailed nonfinancial disclosures. Forecasts in the reports are mainly found in companies in the pharmaceutical sector than any other sector. Construction and electrical companies tend to have more historical information to boost the investor trust in the company’s reputation. Disclosure of historical information, however, does not have any effect on the trend of analyst forecasts on company progress. The high levels of nonfinancial information increase the expectation of the company. This provides an incentive to competitors to make available additional futuristic information. This increase in financial and nonfinancial information harmonises the operations and decision of investors and financial analyst. This may also affect the allocation of resources within capital markets both locally and internationally (Healy & Palepu, p 440). There are higher levels of strategic and management disclosure in most European countries. The difference in information needs of stakeholders to a company’s financial report affects the perception that the report has on the stakeholders. Private investors perceive the notes disclosures to be of little importance as compared to other parts such as the financial statements, management commentary. Of least importance is the auditor’s report. Professional investors and financial analyst on the other hand perceive notes disclosures to be of more importance followed by the financial statements. Journalists’ perceptions differ greatly from all other users. While other users rank the financial statements as the most important part of the report, journalists rank the notes and disclosures highest followed by management representation. While all other stakeholders unanimously agree that disclosure of audit fee is less important, journalists consider plant and equipment to be of less significance. The research could however be termed unreliable in this segment as the number of journalist interviewed was low. In general the financial reports are perceived to be useful by different groups of stake holders. It is found that most users do not read reports from only one sector, instead they analyse different sectors. The management commentary describes the forecasted development of business activities and relations in the past financial year. This segment of the report was rated the most needed information element by most users by Gardner &Martinko (1988). Information regarding corporate social responsibilities is of less importance compared to all other disclosures. The information regarding the usefulness of management commentary is still insufficient and therefore formulation of recommendations is not possible. The cost benefit analysis of research in this area could be used as an indication of the need of improvements in financial reports. The description of forecasted development in business activities and relationships are the two most needed management commentary information elements that can imply a necessity to spend more resources. The rank of preparedness in the management commentary may lead policy makers to obligate its inclusion in financial reports. The Future of Narrative Reporting There is uncertainty of the future of narrative disclosure. Most reports do not disclose enough information and the quality of content of narrative still needs more work. The legal requirements create a situation where companies release complicated reports with the main aim being to meet legal obligations. These types of disclosures are not reader centred and are therefore difficult to read and understand. Contrary to this, lax regulations create a lack of uniformity in narrative disclosures. In this way the investment decisions are undermined as the company can manipulate the information they give to please the investor despite dismal performance within a fiscal year. Attempts at harmonisation of disclosures are encouraged by identification of the factors that encourage the said disclosures. According to Weetman & Collins (1996), probing the affiliation of non-financial disclosures with the earnings forecasts, it is possible to improve the understanding of analysts’ expectation. It is also possible to understand the role of the types of non-financial disclosures in formation of the investor expectation. Factors Affecting Narrative Reporting In a commentary of the case of social and environmental disclosure in the Indian banking sector, Lang & Lundholm (2000) indicate some drivers of non-financial report. These include strategic management of corporation’s reputation, staff motivation, philanthropy and cost effectiveness. The research by Rakhi & Deepak (2011), also indicated that corporate size is an important factor influencing reporting practices, other factors are the life cycle of the company and more especially is the maturity stage. There however exist discordant view as to whether there exists a positive link between corporation disclosures and the overall profitability of a corporation. The extent of disclosure is affected by the capital market transaction wherein firms have incentives for disclosures which reduce the information asymmetry and consequently reduce external finances (Healy & Palepu, 2001, p 438,440). Corporate control contest affect disclosures in that dismal performance will result in management disclosing information which would relatively increase the company’s value and excuse the poor performance. Stock compensation is an incentive in which the management may use disclosures to reduce insider trading allegations and reduce contracting costs. On the litigation costs managers have incentives to disclose information and avoid legal action for inadequate disclosure. The proprietary cost is where the disclosures are controlled if alleged to be competitively detrimental (Healy & Palepu, p 440). Motivations for managers to disclose information are firstly the responsibility of managers to meet set financial goals. Secondly, disclosure may create favour in financial markets if the company is performing well. Thirdly, inadequacy of disclosures motivates managers to give more disclosures to reduce litigation costs. Lastly, disclosures show that the managers are fully aware of the company’s economic environment. By providing disclosures on corporations forecast, the managers show that they are ready to respond quickly to changes in the environment. Determinants of Narrative Reporting Disclosures are determined by the legal structure of the country of operation of the company. In countries with lax legal administration there is inadequate reporting and disclosure practices. North America adopted the common law system while European countries adopted civil law. Judicial obligations towards nonfinancial disclosures are still weak especially in emerging economies (Vanstraelen, Zarzeski, & Robb 2003). In the case of Iran, the country has a weak equity market, no investor protection, inefficient judicial system and enforcement mechanism, and also a poor quality financial reporting system. Despite the stock exchange being established in 1967, the corporate governance issue was not addressed until the early 2000. Even then the external control mechanisms put in place were few and inefficient to handle the growing stock market. The other determinant is the financial market. Companies that take the debt or stock market investment route have shown more stringent reporting practices. They have quantum disclosures which are higher than corporations that do not access the financial markets. This situation is amplified by the adaptation of privatisation and liberalisation policies and listing of local companies in foreign stock markets. This implies that there is need of compliance with the international standards of financial and non-financial disclosures. Issues of the marketing a corporations product affect their competitive position. The extent of non-financial disclosure included in the fiscal reports may have significant effect on the competiveness on the corporations’ products in the market. With more appealing disclosure, a corporation will get higher investment in technology and consequent high scale and quality of production. This results in profitability and even greater investor expectation in the disclosures. Social and managerial obligations create conflicts for managerial reporting strategies. While the social branch argues for managers to treat all stakeholders fairly irrespective of power, the managerial branch posits that the management is supposed to meet the expectation of the most powerful stake holders. Conclusion Narratives in financial reports are important as they aid the corporate social responsibility of the current generation accounting. It is pertinent in the annual report which is increasingly becoming narrative in format. The annual report is the primary medium with which corporations communicate with shareholders. From the shareholders point of view, the annual report is the means of disclosure of corporate information by public companies. The inclusion of narratives satisfy the purpose of financial reporting as it influences decision making and aids in discharge of managerial accountability. Narratives are included as a form of legal responsibility as under the consolidated securities acts, a corporation must comply with disclosure rules. All facts that pertain to shareholders and investors must be disclosed. The material must be free of misstatement. Disclosure of narrative is also a form of social responsibility. With the increasing depth of the role played by corporations in societies, the demand for social responsibility is increasing. Narrative has become a means by which corporations meet the demand for social responsibility. It is the responsibility of the corporation to provide information in a fluent comprehension standard that meets the stakeholders’ skills. This information should enable the shareholders make informed investment decisions. There is a need to evaluate the quality of information to ensure its usefulness. As narratives are tools of investment decision making, it is important to ensure that the information is accurate and of easy readability to the stakeholder contrary to which they would have no value. The quality of narratives directly relates to the aptitude of investors to make cognizant investment resolutions. Definitive methods of judging narrative quality are however lacking. By indication of adequate reporting approach, the quality of narratives will improve. 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