Chapter 6

Products of the
financial reporting process

©2018 John Wiley & Sons Australia Ltd

 Learning objectives

After studying this presentation you should be able to:

6.1evaluate the importance of the identification of the
reporting entity
6.2outline the debate surrounding the length and
frequency of reporting periods
6.3discuss the practice of manipulating reported
earnings in the production of financial information
 Learning objectives

6.4outline the debate surrounding the exclusion of

intangibles and intellectual capital from the financial
reporting process
6.5explain the options available to companies
reporting voluntary disclosures
6.6identify three theories that explain the motivation
for voluntary disclosures in annual reports.
Presentation overview
 Identification of the reporting entity

• For financial statements to be meaningful, the entity

whose economic activities are being reported must be
clearly identified.
• Under the IASB definition, a reporting entity is not
necessarily the same as a legal entity as the entity
could include multiple legal entities.
• If a legal entity controls other legal entities, it should
prepare financial statements on a consolidated basis
thus reflecting the economic resources and claims of
the group of entities as a whole.
 When information is reported

• International accounting standards require financial

reports to be presented at least annually.
• In many countries, listed companies are required to
produce interim financial accounts.
• Real‐time reporting, such as with XBRL, opens up the
possibility of non‐standardised reporting periods, so
that uniformity is surrendered for flexibility.
 When information is reported

• Australia’s Corporate Law Economic Reform Program

(Audit Reform and Corporate Disclosure) Act 2004
aimed to restore public confidence in corporate
Australia by requiring:
– better disclosure in both the annual and half‐
yearly financial reports
– the continuous disclosure regime for Australian‐
listed companies.
 When information is reported

• Australian‐listed companies also comply with

Australian Securities Exchange (ASX) listing rules,
which require disclosure of share‐price‐sensitive
information as soon as the company becomes aware
of it.
• Share‐price‐sensitive information is any information
that a reasonable person would expect to have a
material effect on the price of the company’s shares.
 When information is reported

• Arguments for standardisation of reporting periods:

– The four main arguments for standardisation of the
accounting cycle into a 12 month reporting
period:
1. The standardisation of reporting periods allows
investors to compare and evaluate the relative
effectiveness of managements of different
companies or reporting entities.
 When information is reported

• Arguments for standardisation of reporting periods:

– The four main arguments for standardisation of the
accounting cycle into a 12 month reporting
period:
2. The shareholder requirement for dividends
makes it necessary to close the books, calculate
profits and declare a dividend based on those
profits.
 When information is reported

• Arguments for standardisation of reporting periods:

– The four main arguments for standardisation of the
accounting cycle into a 12 month reporting
period:
3. Various company acts require entities under
their jurisdiction to supply shareholders with
annual balance sheets and profit or loss
accounts.
 When information is reported

• Arguments for standardisation of reporting periods:

– The four main arguments for standardisation of the
accounting cycle into a 12 month reporting
period:
4. Before the twentieth century, stewardship was
more important than measuring a rate of return
on capital. Accounts were seen as control
mechanisms rather than measuring rate of
return. Control required standardisation of the
reporting period.
 When information is reported

• Arguments for a more flexible approach to reporting

periods:
– Standardisation may result in accountants
apportioning unfinished operations and allocating
assets to an arbitrary accounting period of 12
months.
– Chambers argues that the appropriate accounting
period is determined by the nature of the entity, so
that it should reflect the earnings cycle of the
reporting entity.
 When information is reported

• Arguments for a more flexible approach to reporting

periods:
– Johnson & Kaplan argue that standardisation puts
pressure on managers to produce profits over short‐
term periods.
 When information is reported

• Arguments for a more flexible approach to reporting

periods:
– Luther quotes several authors who argue that to
overcome the problems created by standardisation,
annual accounts should have a cumulative
component because they are tentative and
conjectural statements, the truth of which cannot be
verified until the reporting entity has run its entire
course.
 When information is reported

• Interim reporting:
– Reports issued between annual reports are called
interim financial reports. If they are produced they
should contain the following components:
• condensed balance sheet
• condensed income statement
• condensed statement of changes in equity
• condensed statement of cash flows
• selected explanatory notes.
 Manipulation of reported earnings

• It is suggested that the main reason management

manipulates the accounts is the desire to influence
wealth transfers among the various stakeholders
including management, controlling shareholders, other
shareholders and potential shareholders.
• Management has an information advantage over
outsiders including auditors; this is a moral hazard.
• While auditing reduces the moral hazard problem, it
does not eliminate it.
 Manipulation of reported earnings

• Accounts open to manipulation because:

– Managers and controlling shareholders take
advantage of the information asymmetry between
themselves and existing and potential
shareholders.
– Communication between management and
outsiders within the accounting system is limited to
financial information.
 Manipulation of reported earnings

• Earnings management:
– Bottom-line profit – widely used indicator of
performance.
– Depends on the timing differences that arise
between accrual and cash accounting.
– Tempting for managers to match analysts’
forecasts.
– Parfet differentiates ‘good’ from ‘bad’ earnings
management practices.
 Manipulation of reported earnings

• Income smoothing:
– Management artificially manipulates earnings to
produce a steadily growing profit stream:
• Above-normal profits in good times are
artificially reduced by certain provisions.
• These provisions are called upon inflate the
reported profits in bad times.
– A new management team may reduce current
income so that reported low income levels may be
blamed on the previous management.
 Manipulation of reported earnings

• Pro forma reports: massaging earnings:

– Pro forma results are primarily used to show ‘as
though’ results.
– Pro forma earnings are also known as cash
earnings, core earnings, adjusted earnings or
earnings before certain items.
– Critics claim that it is used in order to turn a loss
under the generally accepted accounting principles
(GAAP) into a profit under pro forma reporting.
 Manipulation of reported earnings

• Pro forma reports: massaging earnings:

– Accounting regulations may result in inaccurate
reporting.
 Manipulation of reported earnings

• Pro forma reports: massaging earnings:

– Voluntary disclosures:
• Fill the void between what can be reported
within accounting rules and the drivers of value
generation within firms.
• Often included when responding to media
attention.
• May relate to human resources, the environment
or community.
 Exclusion of activities from the
financial reporting process

• Intangibles:
– Traditional accounting systems are not able to
provide information about corporate intangible
assets.
– Intangibles are seen to be the reason the book
value of corporations has been shrinking in relation
to market value.
– Intangible assets are defined as identifiable non‐
monetary assets without physical substance.
 Exclusion of activities from the
financial reporting process

• Intangibles:
– AASB 138/IAS 38 Intangible Assets:
• declares intangible assets should be recognised
when they generate measurable, future
economic benefits for the reporting entity
• prohibits the recognition of brands,
mastheads, publishing titles, customer lists.
 Exclusion of activities from the
financial reporting process

• Intangibles:
– Expenditure on research, training, advertising and
start-up activities, are not intangible assets.
– Revaluations are restricted to those intangibles for
which there is an active market.
 Exclusion of activities from the
financial reporting process

• Intellectual capital:
– Refers to:
• Capital created by employees or purchased, such
as patents, computer and administrative systems,
concepts, models research and development.
• Relationships with customers and suppliers that
consist of brand names, trademarks and the like.
• Capital embedded in employees, such as through
education, training, values and experience.
 Exclusion of activities from the
financial reporting process

• Intellectual capital:
– Only intellectual capital that has been purchased
will be recognised in the financial statements.
– Knowledge organisations’ assets are their
employees because of the increasing tendency for
technology to be embodied in intellectual property
and labour.
 Exclusion of activities from the
financial reporting process

• Intellectual capital:
– The rate of return to intellectual capital investment
can be determined only through an analysis
involving original expenditure data.
 Voluntary disclosures

• The annual report is the traditional home of the

published financial statements.
• The annual report can be used as a marketing tool as
well as a conveyor of a particular organisational image
to its readers.
 Voluntary disclosures

• Narrative voluntary disclosures in annual reports

provide the means by which management can report
corporate achievements.
• Impression management is said to be proactive when
it is designed to improve corporation’s image.
• Language can be used to blur or bias culpability.
 Voluntary disclosures

• Electronic reporting:
– Using websites, message boards and blogs.
– Electronic publishing is often confusing,
unpredictable and difficult to monitor.
– Both financial and non-financial information is
disclosed on reporting entities’ websites.
– The International Accounting Standards Board
(IASB) has developed a code of conduct for Internet
reporting.
 Voluntary disclosures

• Electronic reporting:
– The IASB guidelines advise that the:
• boundaries of financial reports should be clear
• content of financial reports should be the same
as the reporting entity’s paper‐based reports
• financial reports should be complete, clearly
dated and timely
 Voluntary disclosures

• Electronic reporting:
– The IASB guidelines (continued):
• information provided should be user friendly
and downloadable
• information should be appropriately secured to
ensure reliability.
 Voluntary disclosures

• Electronic reporting:
– Extensible Business Reporting Language (XBRL) is a
language for electronic communication of financial
data. Major benefits include:
• It makes continuous disclosure by reporting
entities possible.
• Cost saving in the preparation, analysis and
communication of business information.
• Improved accuracy and reliability to all those
involved in supplying or using financial data.
 Voluntary disclosures

• Creating an XBRL document:

 Why entities voluntarily disclose

• There is a need to supply information useful for financial

decision making.
• Information should be available to groups other than
investors because the interactions of a company are
not limited to just shareholders but to other
stakeholder groups.
• An entity has multiple responsibilities extending beyond
its legal obligations.
• They contain two antithetical forms of accountability:
dialogue and accounting.
 Why entities voluntarily disclose

• Management motivation to disclose:

– Deegan lists ten reasons for voluntarily disclosure:
1. to comply with legal requirements
2. because of economic rationality arguments
3. because of accountability to stakeholders
4. because of borrowing requirements
5. to comply with community expectations
 Why entities voluntarily disclose

• Management motivation to disclose:

– Deegan lists ten reasons for voluntarily disclosure:
6. to ward off threats to organisational
legitimacy
7. to manage powerful stakeholders
8. to forestall regulations
9. to comply with industry requirements
10. to win reporting awards.
 Why entities voluntarily disclose

• Management motivation to disclose:

– O’Donovan’s suggests that management disclose
environmental information in annual reports to:
• align management’s values with social values
• pre-empt attacks from pressure groups
• improve corporate reputations
• provide opportunities to lead debates
• secure endorsements
• demonstrate strong management principles
• demonstrate social responsibilities.
 Why entities voluntarily disclose

• Research into annual reports:

– Researchers build theories about why
management choose to disclose certain
information.
– The collective name given to this theorising and its
associated research is corporate social
responsibility (CSR) or corporate social reporting.
 Why entities voluntarily disclose

• Research into annual reports:

– The most common theories about why
management would want to disclose its actions in
annual reports are accountability theory,
legitimacy theory and stakeholder theory.
 Why entities voluntarily disclose

• Research into annual reports:

– Accountability theory:
• Views corporations, through their management,
as reacting to the concerns of external parties.
• Involves monitoring, evaluation and control of
organisational agents.
• Focuses upon the relationship between the
corporation and users of its annual reports.
• Monitors, evaluates and controls management.
 Why entities voluntarily disclose

• Research into annual reports:

– Legitimacy theory:
• The annual report is a tool with which
management signals its reactions to the
concerns of society.
• The underlying assumption is a social contract
between society and the organisation.
• Successful legitimation depends on reporting
entities convincing society that a congruence of
actions and values exists.
 Why entities voluntarily disclose

• Research into annual reports:

– Stakeholder theory:
• Two theories:
– Ethics-based theory prescribes how
organisations should treat their stakeholders.
– Managerial or positive-based theory
emphasises the need to manage particular
stakeholder groups, especially powerful
ones.
 Summary

• The importance of the identification of the reporting

entity.
• The debate surrounding the length and frequency of
reporting periods.
• The practice of manipulating reported earnings in the
production of financial information.
• The debate surrounding the exclusion of intangibles
and intellectual capital from the financial reporting
process.
 Summary

• The options available to companies reporting

voluntary disclosures.
• The three theories that explain the motivation for
voluntary disclosures in annual reports.