Agency Problem and Disclosure of Financial Statements

One of the key concerns with regards to separation of ownership and management is the creation of agency problem. This essentially refers to the risk of the managers acting in their own interest rather than the shareholders. There is a need to control this and typically various measures are undertaken to minimise the same. The costs involved in this process are called as agency costs and typically need to be minimised by introducing various measures to align the interests of the managers with that of the firm and shareholders (Deegan, 2014). One of the key mechanisms in this regards is the disclosure regarding financial statements which are made by the companies on a regular basis usually quarterly, These financial statements provide vital information to the key users in relation to the company’s financial performance in the heighted past period usually the previous quarter or year. Dissemination of this information allows the users to take prudent decisions in relation to their engagement with the company (Damodaran, 2015).

In the above context, the process of financial accounting gains relevance. This is because the underlying process of recording, summarising and reporting of financial transactions in the form of financial statements is referred to as financial accounting. It is imperative to note that financial accounting is different from management accounting as the underlying audience is different in both processed. Management accounting is essentially aimed at providing information to the management so as to assist in decision making and sharply in contrast with financial accounting (Dunn, 2010). Financial accounting is essentially directed towards external users particularly shareholders, lenders and creditors. These financial disclosures are aimed at fulfilling the informational needs of these users.  For instance, shareholders need to review the financial performance of the business based on which decision is taking whether to continue with the ownership of stock, enhance stock ownership or liquidate the existing holdings. The potential investors also take decision with regards to investing or not based on financial information provided by the company (Melville, 2011). Additionally, lenders also are interested in the financial position and performance so that they can decide whether the company has the capability to service the debt and meet the repayment obligations. Another key stakeholder are creditors which have given raw material and other services on credit to the company and hence any failure of the company to stay afloat could lead to loss of money (Parrino and Kidwell, 2014).

The financial reporting highlights the information primarily in the form of three key statements. One of these is the income statement. This provides an indication of the underlying operational profitability of the business as it lists down the revenues and also the various expenses (including tax) to arrive at the profit/loss that the firm has made post tax. The various expenses are segregated so that the users can compare the performance with previous year and analyse respective changes (Petty et. al., 2015). This is significant from the perspective of shareholders (both current and potential) since the price of the share of the firm is closely linked to the earnings. Further, there are analysts who are keenly watching the performing of public listed companies and the share price reaction for these is based on the profits that are reported by the company in the given period. Typically, higher profitability would lead to a better valuation for the company compared to one which has very thin profit margins (Brealey, Myers and Allen, 2014).  The lenders also tend to be interested in the income statement as the operating profit is a significant benchmark for them. This is because this highlights the ability of the company to pay interest on regular intervals without defaulting on obligations. A firm which is consistently making operational losses is highly likely to default on the interest payment and therefore lenders might have to rely on the offered collateral if present (Elliot and Elliot, 2017).

Financial Accounting vs Management Accounting

Another integral component of financial statements reported by companies is balance sheet. This highlights the financial position of the company at a particular date which is usually the end of quarter or a financial year. The balance sheet has three key items namely assets, liabilities and shareholders’ equity. These are balanced by the underlying accounting equation as per which assets is equal to the sum of liabilities and shareholders’ equity (Damodaran, 2015). These are further subdivided into other elements for more detailed description of the financial position. For instance, on the asset side, the assets are divided into current assets and non-current assets which the former referring to short term assets unlike the latter which are long term assets (Gillespie, Lewis. and Hamilton, 2004). The current and non-current assets are further divided into other sub-categories so as to provide detailed information of the external users. Similarly, liabilities are also sub-divided into current and non-current liabilities on the basis of the expected cash flow from these. The details of each of these are also highlighted so that the users can identify the respective components of the current and non-current liabilities. Finally, the equity reflects on the share capital of the company along with retained earnings (Dunn, 2010).

The balance sheet provides vital information to the various users based on their respective needs, The capital structure of the company highlights the extent of debt and equity for the financing of assets and is useful for all the users. A capital structure that is skewed with very high debt levels would enhance the default risk with regards to repayment and hence the returns expected by shareholders and lenders would be higher. Further, the valuation of the company is also impacted by the capital structure (Brealey, Myers and Allen, 2014). Additionally, investors perform ratio analysis to analyse liquidity, efficiency and solvency which require the various items listed in the balance sheet. The liquidity ratios are relevant to creditors as poor performance in this regards would imply that the company is not a situation to entertain current liabilities. As a result, the creditors could potentially provide a lower credit period or in extreme cases may demand cash payments with zero credit (Petty et. al., 2015). The solvency ratios are relevant to lenders since it highlights the long term liquidity of the company which is vital for long term lenders since the debt repayment is expected to happen over the long run. Further, the long term lenders also tend to insert various covenants related to solvency ratios which should not be breached or else the loan facility needs to be repaid (Elliot and Elliot, 2017).

Another component of financial reporting is the cash flow statement which essentially highlights the amount of cash that has been paid and received by the business during the highlighted period. This is used to derive the closing cash balance and essentially uses the opening cash balance as the starting point and make relevant additions and deductions to arrive at the closing balance. The cash flows in this statement is indicated from three activities namely operating, investing and finance (Deegan, 2014). Useful information is communicated to the users from this statement as unlike the other statements (i.e. income statement, balance sheet), cash flow statement is based on cash receipt basis. Hence, it presents a more accurate picture of the business since it is based on actual cash realisations by the business which is not the case with income statement where credit sales may be made with accounts receivables balance in the balance sheet. (Damodaran, 2015). It is imperative that actual cash must be received by the business so as to highlight that the business is genuine and also this provides information on the debt repayment and finance raised from various sources such as debt and equity. It is noteworthy that besides the above three key elements namely income statement, balance sheet and cash flow statement, there are notes to account which provide further detail on individual items listed in the above three major components (Gillespie, Lewis and Hamilton, 2004).

Financial Statements and Users

Considering the importance of financial accounting and the underlying information, it is imperative that it must be accurate so that the information has utility for decision making. In this regards, a crucial role is played by the accounting standard which are essentially principles, procedures and standards that the accounting policies of the company are to be based on. This ensures that the management of the company cannot randomly alter the accounting policy in order to meet their ulterior motive and thereby misrepresent the financial statements (Deegan, 2014). Consider for example, accounting policy regarding depreciation. If flexibility is allowed regarding this, then the management can over-represent or under-represent the depreciation expense thereby manipulating the profit based on the expectations of the shareholders and analyst community. A similar case is exhibited with regards to inventory where the management can influence the cost of goods sold and hence the profit reported. The prevalence of accounting standards on a national basis helps avoid this flexibility to the company management (Goodwin, Ahmedand and  Heaney, 2008).

Further, the presence of accounting standards also enhances the utility of the information from the perspective of users. This is because the accounting policies tend to remain constant over various periods and hence a comparison can be drawn between the current performance and the past performance (Schipper, 2005). The difference observed would not be impacted in any major way by the changing accounting policies and hence this change in performance is attributed to the company’s operations which can enable the users to engage in prudent decision making. Additionally, the existence of accounting standards also ensure that a consistent set of information is presented in a defined presentation format which the users are used to in course of time (Whitinhton, 2005). If on the other hand, the accounting policies were changing every now and then, the users would have a very difficult time in interpreting the financial performance in isolation of the accounting policies. The presence of accounting standards also ensures that results across companies especially in the same industry can be compared as the accounting policies would be similar. As a result, the users can opine if the performance of a given firm is inferior or superior compared to peers (Shil, Pramanik and Das, 2009).

Some of the examples with regards to accounting standards are highlighted below. Consider IAS 14 which deals with the measurement and presentation of plant, property and equipment. It highlights that while initially these items are represented at cost but at later dates these should be represented at their fair value. Further, depreciation should be charged on an annual basis and in the balance sheet the net value ought to be reported (Deegan, 2014). This ensures that there is consistency with regards to recognition, measurement and reporting of plant, property and equipment across all firms. Further, the presentation of crucial elements such as cash flow is also covered by relevant accounting standard which ensures consistency across different companies (Elliot and Elliot, 2017). This standard is IAS 7 which essentially drives the fragmentation of cash flow statement into operating, investing and financing activities. Another relevant accounting standard is IAS 2 which related to inventories and lists down the acceptable methods for valuing the inventory and also lists the criterion for changing the valuation methods. The existence of these accounting standards clearly limits the room available to the management to deploy creative accounting and is vital to instil confidence amongst the users of financial information (Finch, 2008).

Income Statement and its Importance

Additionally, there have been attempts to achieve harmonisation of accounting standards globally so as to allow higher comparison amongst firms situated in different countries. A key milestone in this regards is the conceptual framework which essentially forms the basis for the accounting standards globally. The conceptual framework highlights the basic principles of accounting which tend to be adhered with even though small changes in the actual standards may be made depending on the underlying environmental factors (Shil, Pramanik and Das, 2009). Key elements with regards to conceptual framework include the definition of asset and liability along with the underlying conditions which ought to be satisfied before these are recognised. Further, the general measurement principles post recognition are also covered (Finch, 2008)..  This further highlights the need to have accounting standards.

In respect of UK, a pivotal role with regards to financial statements is played by Companies Act 2006. The relevant provisions for financial reporting are highlighted in PART 15 of this Act named “Accounts and Reports”. As per s. 386, it is imperative that company should keep adequate company records highlighting the financial transactions. Further, s. 387 makes contravention of s. 386 a punishable offence while s. 388 lists the time duration for which these records ought to be kept. Section 390 defines the financial year for the company while s. 392 details the procedure for changing the accounting year for the company. Section 393 requires that the accounts of the company should present a fair and unbiased view of the accounts. Also, as per s. 395, the respective individual accounts should be prepared as per the international accounting standards. The criterion for preparation of group accounts has also been highlighted besides highlighting in s. 407 that financial reporting should be consistent across the parent and all the subsidiaries (Elliot and Elliot, 2017).

Section 412 requires the companies to report detailed information regarding remuneration and benefits received by the directors. Section 414 makes the board of directors accountable for any misrepresentation in the financial statements and thereby requires them to sign the same before release. Further, there is requirement of directors report and also the underlying contents are specified under s. 418. Besides, the reporting requirements for the various companies have been listed based on their underlying size and considering whether these are listed or unlisted entities.  Additionally, the procedure for approaching the relevant courts in case of any discrepancy in the financial report has also been outlined. Finally, the liabilities of the erring directors for misrepresentation or falsification of financial statements or accounts has also been outlined on the basis of the underlying situation.  These provisions also serve a similar purpose as has been indicated for the accounting standards (Dunn, 2010).

Based on the above discussion, it is apparent that the disclosure of financial information is essentially in the form of balance sheet, income statement and cash flow statement coupled with detailed notes to account. These three financial statements tend to complement each other and provide vital information to the external users, which is the essential purpose of financial accounting. The users desire this information so that they can take relevant decision based on their respective nature of interest. The shareholders typically take investment decisions, lenders take decisions regarding lending money while creditors decide if credit ought to be extended. A crucial role is played by the accounting standards and conceptual framework which tend to limit the management leeway with regards to creative accounting and hence enhance the overall accuracy and comparability of the current financial performance to past performance of the same firm and the present performance of the peer group companies. In addition to the accounting standards, various rules have also been put in the US through the Companies Act 2006 which highlight the accurate and fair information should be represented and also puts various restrictions in this regards based on the size and listing of the company. These measures go a long way in assisting the users to draw critical information from the regular financial disclosures provided by various companies.

References

Elliott, B. and Elliott, J. (2017) Financial Accounting and Reporting, 18th Ed., Harlow : Financial Times Prentice Hall

Goodwin J, Ahmedand K and  Heaney R (2008) The Effects of International Financial Reporting Standards on the Accounts and Accounting Quality of Australian Firms: A Retrospective Study. Journal of Contemporary Accounting & Economics, 4(1), pp. 89-119.

Parrino, R. and Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London: Wiley Publications

Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., and Nguyen, H. (2015). Financial Management, Principles and Applications, 6^th ed..  NSW: Pearson Education, French Forest Australia

Schipper, K. (2005) The introduction of International Accounting Standards in Europe: Implications for international convergence, European Accounting Review, 14 (1), pp. 101-126.

Shil, N., Pramanik, A.K. and Das, B. (2009) Harmonization of Accounting Standards through Internationalization, International Business Research, 2(2), pp. 194-201

Whitinhton, G. (2005) The adoption of International Accounting Standards in the European Union, European Accounting Review, 14 (1), pp. 127-153