Financial Statement Reporting Practices & Earnings Forecast - Essay Example

FINANCIAL STATEMENT REPORTING PRACTICES & EARNINGS’ FORECAST Prepared by (Name) Professor’s Name Course Name Institutional Affiliation Date Introduction Until recently, the level of potential investor’s confidence on the immediate quality and integrity of company financial reports continues dwindling and reflecting malpractices on the part of management team; being the sole preparers of annual statements. There has been continued media reporting on firms engaging in preparation of annual reports that portray intensive fraudulent earnings, inflated asset values and understated liabilities; depicting rather systematic deficiencies in the manner for which accounting reporting practices and corporate governance mechanisms allow the generation of less accurate and biased financial information to the public as a whole. There have been also intensive threats as most earnings forecasts are subjected to manipulation. In fact, the current number of earnings restatements by corporate entities, within the wake of reporting malpractices, has continued to increase while the frequency attributed with companies beating analysts’ forecasts of earnings also skyrockets annually. This essay is committed to portraying the assumption that specific financial reporting practices are highly associated with less accurate and biased forecasts and, also goes ahead to identify effects attributed to corporate governance mechanisms on the relationship between analysts forecasts and financial reporting practices. Specific Financial Reporting Practices that Prompt less Accurate or Biased Forecasts Lev (2003,p.30) notes that fraudulent company’s earnings can be successfully conceptualised as well as identified only in the event that it is deemed to be relative to true earnings as opposed to GAAP earnings. It is noted that the ever-evolving generally accepted accounting principles (GAAAP), which is highly adopted in the United States of America by FASB under close supervision of the Securities Exchange Commission, contains a detailed set of rules and policies that seek to oversee reporting activities related to measurement, valuation and, financial reporting of assets, earnings and liabilities (Lev, 2003). However, the degree for which this framework sets to accomplish its objective- provision of quality financial information; and earnings to be specific, in order to foster correct investor’s valuation processess and close monitoring of management continues to be challenged now as never before. Numerous researches have been conducted to ascertain whether FASB provision of earnings being a perfect indicator of a company’s present and continual capacity to produce favourable cash flows as opposed to presenting information that is limited to the financial effects of both cash inflows and outflows (Fields, Lys, & Vincent, 2001). However, it is established that a company’s reported earnings are far much correlated with their respective stock prices and returns as opposed to their cash flows derived from daily operations. This is attributed to the fact that earnings, despite being a probable subject of manipulation, depicts’ a managers best estimates in relation to future outcomes like in the case of pension expenses or even product warranty commitments; whereas, on the contrast, cash flows from operations are deemed to be backward looking and can also be manipulated. Nelson, Elliott & Tarpley (2002, p.179) argues that even the most sufficient and reliable accounting principles can never be legislated in unbiased manner and further noted that earnings manipulation is greatly associated with estimations. In fact, the issue that arises in the course of distinguishing between honest and intentional misestimates in reporting earnings provides a platform for extensive manipulation. For example, in the case of the difficulties that arises out of fulfilling pension commitments- a fundamental expense of labour-intensive industries- it really depends on both the future returns or yield on the underlying pension-based assets, which were previously set aside for this purpose (Nelson, Elliott, & Tarpley, 2002). Thus, any increase in the level of expected returns results to a lower pension expense and higher reported earnings. Earnings forecasts and manipulation can be executed in so many different ways. Accounting earnings manipulation can occur in the event that reported earnings are misstated without affecting the underlying level of cash flows or other activities like investment and marketing operations. WorldCom Corp’s move to record $7B of its expenses as capital expenditures resulted to inflation of earnings by a similar figure (Fields, Lys, & Vincent, 2001). Consequently, real earnings manipulation involves altering of a company’s level of investment or other notable operating activities with a clear intention of affecting overall reported earnings. GAAP consistent earnings forecast manipulation focuses on affecting investor’s immediate perception through the adoption of a considerable level of flexibility permitted by the system. In establishing how the different properties of analysts’ forecasts affect disclosure readability, Lehavy, Li, & Merkley, (2011, p.1110) focuses on dispersion, accuracy as well as overall and common risks attributed to with analysts forecast of annual earnings. The study indicates that less readable of annual reports are attributed to with an increased level of dispersion and less accurate analysts earnings forecasts. Following this line of argument, it can be noted that analysts only focus presenting financial information that potential investors will find valuable at the expense of less accurate forecasts. It is however; challenging to evaluate the significance of these benefits since there lacks a proper benchmark, which should portray the effect potential investors of analysts selecting to adhere to firms with less readable disclosures. In the course of establishing the immediate effect of 10-K readability on measures of overall and common analysts forecast uncertainty property, postulates that there is a high degree of overall and common uncertainty in analyst forecast information for companies that portray less readable 10-K filings (Lehavy, Li, & Merkley, 2011). The findings also conforms the assumption that analysts face lots of difficulty in generating private information for companies that have less readable reports. Indeed, analysts’ forecasts tend to focus on firms that enjoy better informational environments and have less complex operations as their level of accuracy and dispersion increased while it fosters a decrease in the manner for which uncertainties are measured. It is further argued that analysts are notably timely or even more careful with their forecast of firm’s earnings for which they deem to be more favourable. In the case of a recommendation to certain stock prices, analysts will obviously engage in extreme positive and negative forecast errors as associated with companies rated a Sell. Notably, analysts can also intentionally omit non-recurring items from their earnings’ forecast. This is especially witnessed whenever they rate one company to be more favourable than the other. Effect of Corporate Governance Mechanisms on the Relationship between Analysts Forecasts and Firm’s Financial Reporting Practices Ajinkya, Bhojraj & Sengupta, (2005, p.344) notes that a firm with external directors has a lower capability of engaging in financial fraud as well as earnings management-related activities. These external directors make sure to provide constant monitoring of the quality of financial information being presented and also influence on a company’s voluntary disclosure policy. Given the fact that directors have a fiduciary duty towards shareholders, they are expected to showcase their capacity to ensure high degree of transparency in shareholders’ interest. In regards to this duty, several companies have ensured to establish formal board-level committees that are tasked with the responsibility of monitoring corporate disclosures. Considering that external directors provide imminent level of monitoring disclosure policies and thus, avail operating environments with greater degrees of transparency, then, it is assumed that companies with enormous proportion of external directors possess a greater propensity to issue forecasts (Ajinkya, Bhojraj & Sengupta, 2005). For this case, analysts’ forecasts are deemed to be more specific, accurate and less biased for that matter. Prior research that sought to examine the relationship between institutional investors and a company’s immediate information disclosure policy focused the linkage existing between analyst’s disclosure ratings and institutional ownership. In essence, it is established that companies with sustained improve in disclosure, which arises from these ratings, are subjected to an increase in institutional ownership. Firms with a great number of external directors are likely to release their report earnings in a much earlier period since the fundamental role of these directors extends to monitoring financial reporting practices and process (Ajinkya, Bhojraj & Sengupta, 2005). Firm’s managers are called upon to act to the best of their abilities to foster transparency through issuance of more specific, and accurate forecast. On the contrast, it is argued that managers might embark on acting of their self-interest and thus, decides to disclose less accurate information that what is actual for numerous reasons including insider trading chances and reputational uncertainties of erroneous forecasts. Under this situation, external directors are fairly-positioned to mitigate any managerial self-interest and influence the provision and entire properties of earnings forecasts through constant direct reviews of disclosure policy and encouraging an operation environment that promotes higher degree of transparency. It is important to note that in the United States of America, the New York Stock Exchange (NYSE) provides a listing requirement requiring a firm’s audit committee of the overall board engage in direct discussion with management on information disclosed in press releases that also includes earnings guidance (Ajinkya, Bhojraj & Sengupta, 2005). For instance, Verizon’s audit committee has the responsibility and duty to review and discuss with management team on the proposed public releases of earnings. Opponents of this notion, argue that these external auditors might be ineffective at times given that they are mostly appointed or even have direct allegiance with a company’s management and sometimes the overall board culture might prevent and eliminate possibility of conflicts. Notably though, companies that enjoy a greater number of external directors within their respective boards are likely to frequently issue earnings forecast,, provide issue specific forecasts and also, they are more likely to generate accurate forecasts. Karamanou and Vafeas (2005, p.481) argues that corporate governance mechanism as stipulated by corporate boards, audit committees and ownership attributes is directly linked with management financial disclosure policies and analysis. In consequence, it is determined that effective and efficient corporate governance mechanisms are positively related with underlying quality of financial reporting disclosures. Analysts’ earnings forecasts provide imminent benefits to a firm including the allowing potential investors a favourable evaluation of the existing management team’s capacity to predict future economic events that might translate to high market values (Karamanou & Vafeas, 2005). Effective management earnings forecasts assist a firm with solicitation of funds from capital markets. Efficient corporate governance thus plays a significant role in ensuring that management team will make clear and concise forecasts and might also help reduce the level of agency conflicts through bridging the information asymmetry gap that is present between management and shareholders. Conclusion The discussion above has confirmed that analysts only focus presenting financial information that potential investors will find valuable at the expense of less accurate forecasts. It has further been argued that analysts are notably timely or even more careful with their forecast of firm’s earnings for which they deem to be more favourable. Notably, there has found a positive relationship between effective and efficient corporate governance mechanisms with disclosure of quality financial reporting practices and analysis. It has been successfully argued that a firm with great number of external auditors, presence of audit committee and overall corporate boards enjoys a great deal of quality information relating to earnings. References List Ajinkya, B, Bhojraj, S & Sengupta, P. 2005. The Association between Outside Directors, Institutional Investors and the Properties of Management Earnings Forecasts. Journal of Accounting Research, 43(3), pp. 344-376 Fields, T, Lys, T & Vincent, L. 2001. Empirical Research on Accounting Choice, Journal of Accounting & Economics, 31, pp.235-307 Karamanou, I & Vafeas, N. 2005. The Association between Corporate Boards, Audit Committees, and Management Earnings Forecasts: An Empirical Analysis, Journal of Accounting Research, 43(3), p. 475-679. Lev, B. 2003. Corporate Earnings: Facts and Fiction, Journal of Economic Perspectives, 17(2), pp.27-50 Lehavy, R, Li, F& Merkley, K. 2011. The Effect of Annual Report Readability on Analyst Following and the Properties of Their Earnings Forecasts. The Accounting Review, 86 (3), pp.1087-1115. Nelson, M. Eliott, J & Tarpley, R. 2002. Evidence from Auditors about Managers and Auditors’ Earnings Management Decisions” Accounting Review, 77, pp.175-202 Read More