Effective financial reporting and auditing: importance and limitation

Andrew Higson (1254978)

English

Loughborough University Institutional Repository

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For the full text of this licence, please go to: http://creativecommons.org/licenses/by-nc-nd/2.5/  Effective Financial Reporting and Auditing: Importance and Limitations 1 of 4www.qfinance.comEffective Financial Reporting and Auditing: Importance andLimitationsby Andrew HigsonExecutive Summary• There is a debate about the specification of the objective of financial statements.• Clear specification of this objective is important for the financial reporting standard-setters (so theycan produce consistent and coherent standards), users (so they understand the nature and scopeof financial reporting), external auditors (so they can say whether the financial statements are “fit forpurpose”), and educationalists (so they can teach the next generation).• The lack of clarity about the objective of the financial statements appears to have created a financialreporting expectations gap.• Perceived defects in financial statements have resulted in a call for real-time financial reporting, but thismay have the effect of creating more volatility in share price movements.IntroductionThe major problem with financial reporting is that people with limited financial knowledge can look at a setof accounts and, by attempting to interpret the numbers, feel that they understand what is happening in anorganization. While in simpler times this may have been true, the scale and complexity of modern business,together with the limitations of what can be portrayed in financial statements, means that today’s statementsmay have the capability to mislead as much as they can inform their users.A large telecom business may have over two hundred million transactions a day in its accounting records,and such a scale of activity is almost beyond human comprehension. The complexity, and uncertainty,surrounding some transactions and financial instruments make their inclusion in the financial statementsproblematic to say the least. In the past accounting was defined as “an art of recording, classifying andsummarizing in a significant manner and in terms of money, transactions and events which are, in partat least, of a financial character, and interpreting the results thereof.”1 The need for financial reportingcame about with the development of permanently invested capital (today’s share capital), which requireda return to be made to the shareholders for their investment over a period of time (usually annually). Theseparation of ownership and management, especially in larger organizations, gave rise to the need forthe accountability of the managers (agents) to the owners (principals), the financial statements being aconvenient basis for this. In some jurisdictions financial statements also form a basis for the calculation oftaxation. This subdivision of an organization’s life into artificial accounting periods may not sound exciting,but it is important. It may not cover all aspects of an organization’s activities, but originally this was neverintended.Decision-UsefulnessSince the 1960s, the function of accounting has been increasingly regarded as “to provide quantitativeinformation primarily financial in nature about economic entities that is intended to be useful in makingeconomic decisions, in making resolved choices among alternative courses of action,”2 and accounting wasseen as a service activity.On a simplistic level, the decision-usefulness approach may be intuitively appealing, but it could also beconceptually flawed and an example of circular reasoning: just because some people may take decisionsbased on the financial statements, does this mean that decision-usefulness should be specified as theobjective of financial statements? When one takes a decision, one should be looking to the future—yetthe financial statements say very little about an organization’s future. One should also consider the futureeconomic climate, an organization’s competitors, and expected technological developments; financialstatements say very little about these things. Often short-term investors are more concerned about takingEffective Financial Reporting and Auditing: Importance and Limitations 2 of 4www.qfinance.comtheir decision in anticipation (buy long, sell short) of the publication of the financial statements rather thanwaiting for them to come out, reading them, and then taking a decision.An important component in the debate about the objective of financial statements has been the vagueness ofthe nature, scope and purpose of accounting “theory.” One would have expected developments in financialreporting to have been built on theory and thus be conceptually robust. The focus on unspecified userstaking unspecified decisions, at unspecified times, with unspecified results hardly seems an appropriatebasis for the production of consistent and coherent financial reporting standards, and consequently there is adanger that the financial reporting standard-setters have been building on shifting sands rather than on firmfoundations.The Call for Real-Time ReportingGiven the prevailing emphasis on decision-usefulness, and the perceived limitations of financial statementsin this respect, some analysts and other external parties have been calling for companies to make real-timeaccounting data available to them. The argument is that immediate access to, and a greater quantity of,data about a company should improve users’ decision-making ability and thus improve market efficiency.However, if companies were to adopt real-time reporting (this presumably would be the reporting of resultson a minute-by-minute basis rather than just putting the annual accounts on the internet), would the resultsmake sense?There is a danger that there has been a confusion over the “recording” aspect of accounting and the“reporting” aspect of the financial statements. “Raw” accounting data are simply a means of recording inorder to keep track of the transactions undertaken by an organization—which is obviously very important formanagement to do. The periodic financial statements use these accounting data, and related assumptionsand conventions, to allocate profit to the appropriate accounting period and to present the financial figures ata point in time (this is after the necessary cut-off adjustments and checks have been made). Given the scaleof modern business, one wonders what users would really make of all the data.To allow outsiders access to real-time “raw” accounting data does raise the question as to how exactly itwould lead to greater market efficiency. Indeed, instantaneous access to real-time accounting data may notnecessarily result in greater market efficiency—though greater volatility in share price movements would be adistinctly possible consequence.The Financial Reporting Expectations GapIt is likely there is a financial reporting expectations gap3 composed of two elements, one being anexpectations gap relating to the financial statements, and the other being the audit expectations gap (Figure1). There has been much discussion of the audit expectations gap (some users of financial statements thinkthat the external auditors are there to detect fraud, that they produce the financial statements, that theycheck everything recorded by the client’s accounting, etc.). The audit expectations gap has been a drivingforce behind the expansion of the audit report and has focused the debate about the responsibilities of theexternal auditors. Compared to the discussion about the audit expectations gap, the possibility of a financialstatements expectations gap has almost been ignored.Figure 1. The financial reporting expectations gap. (Source: Higson, 2003, p. 13)It is suggested that one element is the already discussed focus of the accountancy profession on thedecision-usefulness of financial statements. Just because some people do take decisions based on them,it does not mean that they take the right decision. Another problem is the use of financial statements asEffective Financial Reporting and Auditing: Importance and Limitations 3 of 4www.qfinance.coman assessment of “performance”; this is because the financial statements per se say nothing about theeconomy, efficiency, and effectiveness of the organizations that produce them. There is also the tensionbetween the long-term development of an organization and the short-term results contained in the financialstatements. It is easier for users of financial statements to focus on the short-term figures contained insuch statements than to try to look long-term. The broadening of the notion of performance could meanthat financial statements would then be recognized for what they are—an attempt to allocate profit to theappropriate accounting period and to indicate the financial position at a point in time—and that they wouldthen enable the debate about what constitutes corporate performance to really begin.Implications for the External AuditorsOne might assume that the audit report would be saying that the financial statements are “fit for purpose”;however, traditionally the auditors have said nothing about the decision-usefulness of financial statements.Indeed, the Company Law Review Steering Group report4 stated: “auditors have no liability to existingshareholders who rely on their report for investment decisions (for example to buy or sell shares), or actualcreditors of the company who may make similar decisions about maintaining or withdrawing credit, orpotential investors whether of equity or debt, or other potential creditors (for example trade creditors), whorely on the audit report for a view of the financial position of the company.” It is therefore not surprising thatin the United Kingdom, following the Bannerman case5 in 2003, the auditors added a paragraph to theiraudit report which included the advice that: “Our work has been undertaken so that we might state to thecompany’s members those matters we are required to state to them in an auditor’s report and for no otherpurpose … we do not accept or assume responsibility to anyone other than the company and the company’smembers as a body, for our audit work, for this report, or for the opinions we have formed.”The auditors say nothing about corporate economy, efficiency, and effectiveness in their audit report. Theusers have to try to make their own assessment of these things based on the limited amount of data in thefinancial statements available to them.It can be seen that the auditors tend to think of themselves as doing what is required of them (i.e. to followthe auditing standards and ensure that the financial statements have been produced by management inaccordance with financial reporting standards), but I wonder how many readers of financial statements willunderstand this and understand what all these standards mean.ConclusionThe challenges of corporate reporting in the twenty-first century can only be met once there is a realunderstanding about the nature, scope, and limitations of the financial statements and of the role of theexternal auditors.Without a strong theoretical basis, the danger is that the financial reporting standard-setters will merely endup pandering to the perceived needs of the supposed users of financial statements.The word “performance,” in a theatrical sense, could be defined as “an act of make-believe aimed atenchanting an audience.” The existence of the financial statements expectations gap may mean that thisfate has already befallen the phrase “financial performance” (think about Enron’s and WorldCom’s financialstatements!); it is important that it does not befall the phrase “corporate performance.”Making It HappenAn Agenda for Developments in Corporate Reporting• Give consideration to a tighter and arguably more realistic specification of the objective of the financialstatements.• Increase education about the scope and limitations of financial statements and the external audit.• Conduct a proper debate about the nature of communicating corporate performance and theassessment of corporate economy, efficiency, and effectiveness.Effective Financial Reporting and Auditing: Importance and Limitations 4 of 4www.qfinance.com• Reflect on the usefulness of real-time access to corporate accounting data.More InfoBooks:• Deegan, C., and J. Unerman. Financial Accounting Theory. European ed. London: McGraw-Hill, 2006.• Elliott, B., and J. Elliott. Financial Accounting and Reporting. 12th ed. Harlow, UK: FT Prentice Hall,2007.• Harrison Jr, W. T., and C. T. Horngren. Financial Accounting. 6th ed. Upper Saddle River, NJ:Pearson, 2005.• Higson, A. Corporate Financial Reporting: Theory & Practice. London: Sage Publications, 2003.• Riahi-Belkaoui, A. Accounting Theory. 5th ed. London: Thomson, 2004.Website:• Corporate Financial Reporting, the author’s website: www.accounting-research.org.ukNotes1 American Institute of Accountants (AIA), Committee on Terminology (1953). Accounting TerminologyBulletin No. 1. New York: AIA, 1953, p. 9.2 Accounting Principles Board (APB). Statement No. 4: Basic Concepts and Accounting PrinciplesUnderlying Financial Statements of Business Enterprises. New York: AICPA, 1970, para. 40.3 Higson, 2003.4 Company Law Review Steering Group. Modern Company Law for a Competitive Economy: Final Report.London: DTI, 2001, para. 8.127.5 Auditing Practices Board Discussion Paper. The auditor’s report: A time for change? London: FinancialReporting Council, 2007, pp. 11–12.See AlsoBest Practice• Contemporary Developments in International Auditing Regulation• The Effect of SOX on Internal Control, Risk Management, and Corporate Governance Best Practice• Has Financial Reporting Impacted on Internal Auditing Negatively?• Understanding the Requirements for Preparing IFRS Financial StatementsChecklists• International Financial Reporting Standards (IFRS): The Basics• Key Accounting Standards and Organizations• The Ten Accounting PrinciplesFinance Library• Financial Accounting and ReportingTo see this article on-line, please visithttp://www.qfinance.com/auditing-best-practice/effective-financial-reporting-and-auditing-importance-and-limitations?full

Effective financial reporting and auditing: importance and limitations

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Effective financial reporting and auditing: importance and limitations

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