Conservative Financial Reporting - Coursework Example

CONSERVATIVE FINANCIAL REPORTING Every year or probably after three or so months, financial reports have to be made regardless of the type and size of business. As a matter of fact, financial reporting is part ad parcel of business and companies every single day, and this constitutes for a major part of the running of the company’s accounts (Guay, 2008). Financial reports are very important especially to the business. For instance, no company can get willing financing from banks if there are no financial reports. Also, donors and other relevant parties usually work with a firm’s financial reports before giving support. Financial reports usually also help the firm to know its current position, and it becomes easier for a firm to set long term goals when it does financial reporting regularly. Information asymmetry has various negative impacts on the accounting practices of a firm. Poor quality accounting practices are characterized by errors in financial reports, and this shows that the environment in which accounting is done is wrong. Most firms do not think that accuracy in financial reporting helps them directly, but it does; improving the accounting environment and ensuring transparency automatically translates to improved performance and more profits in the company, because mis-pricing of products is ruled out (Bushman, 2005). Several financial reporting documents are used, and they include balance sheets, income statement and statement of retained earnings and a cash flow statement. A firm that does not have transparency in financial reporting usually closes out the opportunities for expansion brought by external and foreign investors. Apart from closing out the opportunity of having investors, it is illegal to have no financial reports or to have financial reports that are faked or altered (Beyer, 2009). A firm’s financial report is a formal document showing the financial undertakings of the firm. In financial reporting, a company should state its financial position by stating and declaring its assets, liabilities and equity. Also, a profit and loss statement is included in a comprehensive financial report, and it shows the profits or losses a company has made, and it therefore shows cost of production, expenses and sales (Catty, 2009). The company should also include a statement of the status or the changes in equity through out the financial year up to the time of reporting. Cash flow statements should also be included, as they show the flow of cash to and from the firm, say in investments, receiving of donations, giving of donations and the flow of cash during the normal operations of the firm. All these should be included in a comprehensive financial report (Chen, 2007). The managers of a firm need financial reports to show them the current position of the firm and to act as a basis on which decisions regarding the firm’s continuity are made. The employees of a firm, too, need financial reports of the firm so that negotiations and bargains between the employees and employers will be transparent and not skewed. Such bargains include those involving compensation schemes, promotions and working conditions (Guay, 2008). Investors, both local and foreign, need financial reports so that they will have a clear picture of the firm they are about to invest in. financing institutions like banks and mortgaging companies need financial reports to assist them in making the right decision in debt contracting. Tax authorities of the government need financial reports to assist them in calculations of the tax payments and duties a firm should make. The media, too, also needs financial reports of any firm, and they need such reports not for specific reasons but for reasons that vary with time (Kwon, 2001). Conservative financial reporting is the practice of making financial reports based on specific principles. The traditional method of doing financial reporting is based on the “fair value” principle, whereby the debts are underestimated and the assets are over estimated. The other traditional principle of financial reporting is that whereby the belief system shows that profits are only realized and recognized after making sales. Both of the traditional philosophies are outdated and very unprofessional (Bushman, 2005). On the other hand, the conservative financial reporting method is very modern, professional and effective. This method puts into consideration both debts and assets, and assets are not over estimated. What this principle does is simply account for the volatility of the assets and debts. Also, this principle supports implementation of values objectively and prudent as opposed to doing it subjectively and with unrealistic optimism. This principle’s way of viewing financial value is just very different from other financial reporting principles (Mard, 2007). According to this principle, financial value has three major components in it, and these three components are in relation to each other for the completion of the cycle. These three include a person, an object and a circumstance. The person relates to the object in one way or the other, and this relationship I done within the context of a circumstance that is not fixed, but dynamic and variable. In a nutshell, conservative financial reporting is speedier to recognize losses that it is to recognize profits (Haskins, 2000). One of the best illustrations of the conservative financial reporting principle is debt contracts. In a company, shareholders have the incentive of limited liability in the company. As a result, shareholders try their level best to clear their debts so that the benefits that accrue to having no debt may continue being active to them unlike when hey have pending debts to the company. However, this results to formation of some level of conflict within the company’s structure. Therefore, in order to create harmony, the shareholders can at least hold a certain minimum level of investments in the company (Alexander, 2007). These shareholders are given a sense of security by the company bridging the gap between the dividends of the shareholders and the paycheck by use of certain covenants. Therefore, the requirement for losses is set at a lower level than that of the requirement for profits. What results is more anticipation for losses than for gains, and in this case most people are not disappointed. What results is that most of the people, who were either anticipating losses only or who were not anticipating any gains at all fall on the safer side, and there are therefore no disappointments. This is as opposed to traditional methods of financial accounting, whereby there is full anticipation for gains, and this level is not attained because most people fall short of it by a certain margin (Schilit, 2002). For firms to adopt the conservative financial reporting there are several motivations that can be used. These are grouped from four major institutions, which include the judiciary, security, politics and tax (Bushman, 2005). The Judiciary This is a major arm of every government, ad it has direct influence on the motivation of firms in adopting the conservative financial reporting system. The basic way through which the judicial system can do this is via contracting systems in the firms. According to theorists, firms have from a long time ago had the consciousness of the need for contracts and agreements that are verifiable. This means that firms and contracting parties have all along assumed or created a court system that does not exists, and this court system is what stands for the verifiability of any contract (Lechem, 2002). Therefore, the fact that firms have financial accounting makes it even better for the court system, because contracts are more verifiable. Therefore, the judicial system becomes very easy to apply in such contracts, because the tradition that has been adopted makes contracts very legal and verifiable. The more the judicial system is applied in contracting, the more financial accounting is needed by the firms and their contractors. Therefore, a more developed judicial system will demand for more accounting and verification of contracts, and this will create a rise in the demand and the need for conservative financial reporting (Beyer, 2009). Debt contracting is also another area in which the judicial system can motivate firms to adopt the conservative financial reporting system into their operations. For instance, the manager of a firm will have limited liability as a result of the amount of shares he has in the firm. Because of this, it is harder for the shareholders and even the manager to get funds fraudulently for individual use (Tracy, 2004). As a result, a great demand for funds for compensation to the shareholders will increase, because compensation funds will be used to compensate the shareholders in cases where the pool of cash is missing or is under investigation following the manager’s fraudulent actions of embezzlement. This causes the need for contracting between the firm and its shareholders for the sake of the verification of the compensation scheme. This means that the contracting system will be stepped up, and conservative financial reporting will have to be adopted so that the firm’s compensation scheme can meet the judicial system’s legal requirements for verification (Kwon, 2001). Litigation is another way through which the firms can be motivated and influenced by the judicial system to adopt the conservative financial reporting system. When the rights of those who have invested in the firm, say shareholders, are violated, the judicial system may agree to make the litigation fee higher for the sake of investor’s compensation (Zabihollah, 2002). Firms will therefore not overstate or exaggerate their financial reports, as is usually the case, because the firms will not want litigation fees to be charged in proportion to the seemingly huge figures in the firm’s financial reports. Firs exaggerate their financial reports so that they will get the benefits that accrue to firms of a higher standard, so that they can skip or connive their way out of the set bureaucratic systems for firms and find their way to the top illegitimately. Therefore, such a litigation system enforced by the judicial system will automatically cause firms to do conservative financial reporting so that they will be on the safer side (Alexander, 2007). The Security System The laws governing security in a country also have direct impact on the motivation for firms to adopt the conservative financial reporting system. Security laws are not fixed, but every country has its own unique system of security which is governed by unique laws (Swagerman, 2003). However, one thing is common in all the different countries; the security systems and the laws governing these systems are established to create a smooth running atmosphere for the firms and for the other parties involved, which include auditors, contractors and distributors. The security system has influence on firms for adoption of the conservative financial reporting system in either of the two ways: private or public (Schilit, 2002). Under the private method of influence, the security system governs and implements the laws and regulations governing private contracting by regulating costs and altering the terms. The rules governing liabilities and records that are not genuine are also made clear and they are put into implementation. Every party in the chain of trade is made aware of the standing rules governing their operations and their contracting systems (Smith, 1992). These parties therefore reduce costs and they automatically adapt the conservative financial reporting system so that the proof used in court will not lead to exaggerated bonds and fines. Under the public method, there is a slight contradiction with the private because the public method seems to have the idea that the private method is not enough to ensure maximum honesty from contracting parties. Therefore, it feels that there is need for extra public enforcement for the security system to be able to totally influence and motivate the conservative financial reporting system. This public enforcement system, however, should be totally free from political influence and control, it should have the power to do investigation, it should have the freedom to take measures even on non-criminal cases and, lastly, it should also have the freedom to give consent in criminal cases (Chen, 2007). Such a security system is said to create such an asymmetrical situation as far as gains and losses are concerned, and firms and other relevant parties are instantly motivated to employ a better reporting system so that they will balance between potential gains and potential losses. Also, when the public system is used, there is less political control in such a system especially when there are situations where gains are overstated or losses understated (Zack, 2009). In the private system, costs in contracting are drastically reduced, and the atmosphere becomes more conducive for implementation of the conservative financial reporting system in accounting. As it is the case in the judicial system, litigation in the security system also causes firms and contracting parties to reduce costs and to have a clear reporting system so that charges will not be exaggerated, and this automatically calls for the conservative financial reporting accounting system (Kranacher, 2010). The Political System The government and politics play a major role in motivation of firms in adopting the conservative financial reporting system of accounting. It is generally hypothesize in almost every theory that it is natural, in politics, for those in power to come up with policies that will enable them to stay in power. As a result, you will find a common trend in governments of wanting to have more control over firms so that the government will have the ability to employ people directly under the firms they own or run (Mulford, 2002). This is to gain favor in the sight of potential supporters so that votes, loyalty and bribes will be guaranteed to the political leaders involved. Another hypothesis is that private institutions, for instance private banks, are not developed to a level where they can have some degree of control over firms and over economic development issues. As a result, it becomes necessary that the government comes into the picture so that by controlling such firms, it will be able to have a high degree of control over economical development (Tohmatsu, 2008). Also, in order to control monopoly, capitalism and socialism, the government has to control such firms so that imperfections and imbalance will be eliminated from the economic system. The government also tries to have ownership or control over firms that are weak or poor performing so that these firms can be given a boost so that the society will benefit from this firm (Kwok, 2005). The need for the government to control firms may not be clear, and it might seem to have vague reasons and explanations for the government’s main motive for getting directly involved in control of firms and the economy. However, it is almost a verified truth that political leaders get interested in firms that are very profitable so that they can have a degree of control over such firms for exploitative purposes (Wells, 1992). This, alone, is reason enough for firms to adopt the conservative financial reporting system to prevent exaggeration of gains and understatement of losses. Also, firms that are somewhat weak and underproductive also adopt a less conservative financial reporting system so that they will portray a healthier image to avoid losing total control over the firms to the government (Silverstone, 2007). It may be hard to comprehend why politicians may get so interested in the accounting reports of firms, when it is known pretty well that this is not the only way through which the profitability of a firm can be known (Cunningham, 2002). It is possible to know the profitability of a firm by looking at the stocks, at the national and international trends, by comparing prices against those of similar firms, et cetera. Financial accounts are not the only or the most reliable way of knowing the profitability of a firm. Yet, political leaders are still interested in the accounting reports; there must be an explanation to this (Singleton, 2006). First and foremost, in as much as politicians can use stocks information to estimate the profitability of a firm, it is usually not possible for them to have the detailed reports and records for the stocks. Therefore, it becomes such a daunting task to keep track of the firm’s profitability using stocks (Wells, 2007). Also, prices in stocks are not fully revealed because of the fact that cost of operations vary and fluctuate. Also, for the common interest of investors, information about stocks is not fully revealed to other parties. As a result, the only easy and sure way out for politicians is by getting the accounting reports for the firms, because these reports are well compiled and fully detailed. Also, since intervention in taking control over a firm is not done forcefully, accounting records are used for provision of solid evidence of the firm’s fiscal matters (Mulford, 2002). The Taxation System It is pretty obvious that financial reports and tax payments are directly related, because taxes are charged as a percentage of revenue. It therefore becomes an obvious thing for firms to prefer the conservative financial reporting system so that the taxation burden on them will not be puffed up unnecessarily (Schilit, 2002). Also, the state uses taxation as a way of indirectly getting revenue from the profit making firms, and this also translates directly to political control over these firms. Therefore, firms with higher income thresholds usually have higher taxation rates imposed on them so that the state can make maximum benefit from such firms. This is because it is assumed that the more a firm makes profit, the more it has used the state’s natural and man made resources and it can therefore not be charged the same amount of percentage taxation as for a firm that makes fewer profits per annum (Haskins, 2000). References Alexander, David and Britton, Anne. 2007. International Financial Reporting and Analysis. New York: Cengage Brain. Beyer, Anne and Cohen, Daniel. 2009. The Financial Reporting Environment: Review of the Recent Literature. Stanford: Stanford University. Bushman, Robert AND Piotroski, Joseph. 2005. Financial Reporting Incentives for Conservative Accounting: The Influence of Legal and political institutions. Chapel Hill: University of North Carolina. Catty, James. 2009. Wiley Guide to Fair Value under IFRS. New York: John Wiley and Sons. Chen, Ken and Elder, Randal. 2007. Fraud Risk Factors and the Likelihood of Fraudulent Financial Reporting: Evidence from Statement on Auditing Statements No. 43 in Taiwan. Taiwan: NTUP Press. Cunningham, David. 2002. Financial Statements Demystified. New York: Allen & Unwin. Guay, Wayne. 2008. Conservative Financial Reporting, Debt Covenants and the Agency Cost of Debt. London: Journal of Accounting and Economics. Haskins, Mark, Ferris, Kenneth and Selling, Thomas. 2000. International Financial Reporting and Analysis: a contextual emphasis. New York: McGraw-Hill. Kranacher, Mary and Riley, Richard. 2010. Forensic Accounting and Fraud Examination. New York: John Wiley and Sons. Kwok, Benny. 2005. Accounting Irregularities in Financial Statements: a definitive guide for litigators, auditors and fraud investigators. Michigan: Gower Publishing Ltd. Kwon, Young, Newman, Paul and Suh, Yoon. 2001. The Demand for Accounting Conservatism for Management Control. Netherlands: Kluwer Academic Publishers. Lechem, Brian. 2002. Chairman of the Board: a practical guide. New York: John Wiley and Sons. Mard, Michael and Hitchner, James. 2007. Valuation for Financial Reporting: fair value measurements and reporting, intangible assets, goodwill and impairment. New York: John Wiley and Sons. Mulford, Charles and Comiskey, Eugene. 2002. The Financial Numbers Game: detecting creative accounting practices. New York: John Wiley and Sons. Schilit, Howard. 2002. Financial Shenanigans. New York: McGraw-Hill Professional. Silverstone, Howard and Sheetz, Michael. 2007. Forensic Accounting and Fraud Investigation for Non-Experts. New York: John Wiley and Sons. Singleton, Tommie and Singleton, Aaron. 2006. Fraud Auditing and Forensic Accounting. New York: John Wiley and Sons. Smith, Terry. 1992. Accounting for Growth: stripping the camouflage from company accounts. California: Century Business. Swagerman, Dirk and Verhoog, Willem. 2003. Is Fair Value Fair? financial reporting in an international perspective. New York: John Wiley and Sons. Tohmatsu, Deloitte. 2008. Financial Reporting in Hong-Kong: illustrative financial statements and disclosure checklist. Hong Kong: CCH Hong Kong Limited. Tracy, John. 2004. How to Read a Financial Report: wringing vital signs out of the numbers. New York: John Wiley and Sons. Wells, Joseph. 2007. Corporate Fraud Handbook: prevention and detection. New York: John Wiley and Sons. Wells, Joseph. 1992. Fraud Examination: investigative and audit procedures. London: Quorum Books. Zabihollah, Rezaee. 2002. Financial Statement Fraud: prevention and detection. New York: John Wiley and Sons. Zack, Gerard. 2009. Fair Value Accounting Fraud: new global risks and detection techniques. New York: John Wiley and Sons. Read More