Chapter 6

Products of the
Financial Reporting
Process
PowerPoint Presentation
by Matthew Tilling
©2012 John Wiley & Sons Australia Ltd
Learning Objectives

See page 159

Identification Of The Reporting Entity

• ‘a bounded area of economic activities whose

financial information has the potential to be
useful to existing and potential equity investors,
lenders, and other creditors who cannot directly
obtain the information they need in making
decision about providing resources to the entity
and in assessing whether management and the
governing board of that entity have made efficient
and effective use of the resources provided’.
Identification Of The Reporting Entity

• The Reporting Entity ( legal entity – economic

entity)
• “entity" means any legal entity or other party
(including a person) having the capacity to deploy
scarce resources in order to achieve objectives.
• "economic entity or reporting entity " means a
group of entities comprising a controlling entity
and one or more controlled entities operating
together to achieve objectives consistent with
those of the controlling entity.
 When Information
Is Reported
• International accounting standards require financial
reports to be presented at least annually.
(Fiscal year vs Financial year)

• In many countries, listed companies are required to

produce interim financial accounts. (Such as balance sheet
& income statement)
(ongoing assumption and periodicity assumption )
• Real-time reporting opens up the possibility of non-
standardised reporting periods, so that uniformity is
surrendered for flexibility (XBRL: extensible business
reporting language)
 Arguments for Standardisation of
Reporting Periods 12 months
1. It allows investors to compare and evaluate
managements of different reporting entities. (allows better
comparability between companies)
2. The requirement for dividends makes it necessary to
close the books and calculate profits to declare a
dividend.(more accurate calculation of dividends)
3. Various company acts require entities to produce annual
financial statements. (Legal requirement)
4. Accounts also are a control mechanism and this requires
standardisation of the reporting period.(better stewardship)
 Arguments for a More Flexible
Approach to Reporting Periods
I. Any standardised period cuts across many
uncompleted transactions and therefore requires
arbitrary* apportioning.
II. Better to focus on natural earnings cycle* of business.
III. Reduce short term earnings management. (because
standardisation puts pressure on managers to produce profits over short-
term periods)

*The operating cycle is the period of time between the acquisition of goods
and services involved in the manufacturing process and the final cash
realization resulting from sales and subsequent collections.

*arbitrary: based on random choice , rather than any reason or system

 Annual Report?
• An annual report is a comprehensive report
on a company's activities throughout the
preceding year. Annual reports are intended to
give shareholders and other interested people
information about the company's activities
and financial performance.
• Includes Financial and nonfinancial
information
 Annual Report?
Typical annual reports will include:
• General corporate information
• Operating and financial review
• Director's Report
• Corporate governance information
• Auditor's report
• Financial statements, including Balance sheet also known
as Statement of Financial Position, Income statement also
profit and loss statement, Statement of changes in equity,
Cash flow statement, and Notes to the financial
statements
• Accounting policies
 Annual Report?
What are the purposes of an annual report?
o Accountability of managers.
o Provides information for decision making by
non-management stakeholders
o Means of reporting corporate achievements
o Means of impression management, especially
of positive images
 Interim Reporting
• Reports issued between annual reports are called
interim financial reports.
• Not mandated by IASB
• Required by Australian law for some entities
• Covered by AASB134 and must include:
– Condensed balance sheet
– Condensed income statement
– Condensed statement of changes in equity
– Condensed statement of cash flows
– Selected explanatory notes
– Comparative information
 Manipulation Of
Reported Earnings
Manipulation is defined as “Use of
management’s discretion to make accounting
choices or to design transactions to affect the
possibilities of wealth transfer between the
company and society, funds providers (cost of
capital) or managers (compensation plans)”.
• Manipulation within the law is called Earnings
Management
• Manipulation outside the law is called Fraud
 Manipulation Of
Reported Earnings
• Why does management manipulate the
accounts?
– to influence wealth transfers among the various
stakeholders. Including
• Management, controlling shareholders, other
shareholders and potential shareholders.

• Why are accounts open to manipulation?

– Information asymmetry. (communication between
management and outsiders within the accounting system is limited to
financial information)
 Earnings Management
• Bottom-line profit is the most widely used
indicator of performance.
• Earnings management is defined as a ‘manager’s
use of accounting discretion through accounting
policy choices to portray a desired level of
earnings in a particular reporting period’.
• Can be earnings managed.
– Usually based on the timing differences that arise
between accrual and cash accounting.
 Earnings Management
• Often managed to meet analysts’ forecasts.’
• ‘Good’ versus ‘bad’ earnings management.
- The bad earnings management involves
intervening to hide true operating
performance.
- Good earnings management involves
management taking actions to try to create
stable financial performance.
 Income Smoothing
• Management manipulates earnings to produce
a steadily growing profit stream.

• Allows managers to increase remuneration.

 Pro Forma Reports:
Massaging Earnings
• (Pro Forma accounting, Pro Forma financial
statements, Pro Forma earning)
“Describe a financial statement that has hypothetical
amounts, or estimates, built into the data to give a
"picture" of a company's profits if certain nonrecurring
items were excluded. Pro-forma earnings are not
computed using standard GAAP and usually leave out
one-time expenses that are not part of normal company
operations”.
• Pro Forma earning: are known as cash earning, core
earning, adjusted earning, earning before certain
items.
 Pro Forma Reports:
Massaging Earnings
• (Pro Forma accounting, Pro Forma financial
statements, Pro Forma earning)
“Is a statement of the company's financial activities
while excluding "unusual and nonrecurring
transactions" when stating how much money the
company actually made. Expenses often excluded
from pro forma results include company
restructuring costs, a decline in the value of the
company's investments, or other accounting charges,
such as adjusting the current balance sheet to fix
faulty accounting practices in previous years”
 Pro Forma Reports:
Massaging Earnings
• Pro forma results are primarily used to show ‘as
though’ results. Often used when
– The company has not operated for a full year.
– There is a significant accounting policy change.
– Exclude one-time or unusual items.
• Critics claim they are incomplete, inaccurate and
misleading.
– Firms are more likely to use them when their share
price and earnings decline in order to meet analysts’
expectations and to downplay bad earnings news.
 Exclusion Of Activities From The
Financial Reporting Process
• IAS 16 — Property, Plant and Equipment
• Items of property, plant, and equipment should
be recognized as assets when it is probable
that:
I. it is probable that the future economic
benefits associated with the asset will flow to
the entity, and
II. the cost of the asset can be measured
reliably.
 Exclusion Of Activities From The
Financial Reporting Process
• Accounting regulations may result in inaccurate
reporting.
• Voluntary disclosure can be used to fill the void
between what can be reported within accounting
rules and the drivers of value generation within
firms.
 Intangibles
• Traditional accounting systems are not able to
provide good information about corporate
intangible assets.
‘As much of two-thirds or three-fourths of the real
value of the company is based on intangibles, and
investors are not getting the information they need to
make decisions’.
• This is seen to be the reason the book value of
corporations has been shrinking in relation to
market value.
 Intangibles
• Intangible asset: an identifiable non-monetary
asset without physical substance.
• IAS 38 requires an entity to recognize an
intangible asset, whether purchased or self-
created (at cost) if, and only if:
I. it is probable that the future economic
benefits that are associated to the asset will
flow to the entity; and
II. the cost of the asset can be measured reliably.
 Intangibles
• Examples of intangible assets: patented
technology, computer software, databases,
trademarks, trade dress, video and audio visual
material (e.g. motion pictures, television
programmes), and customer lists.
• AASB138/IAS38 specifically prohibits the
recognition of brands, customer lists and
expenditure on research, training, advertising.
 Intangibles
• Recognised revaluations are restricted to those
intangibles for which there is an active market.
• Active market: is a market in which transaction
for asset or liability take place with sufficient
frequency and volume to provide pricing
information on an going basis.
 Intellectual Capital
• Its an umbrella term that 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 education,
training, values and experience.
• Only intellectual capital that has been purchased
will be recognised in the financial statements
 Voluntary Disclosures
• Voluntary Disclosures appears to be the answer to the
lack of comprehensiveness of financial statement
(Intangibles assets & Intellectual Capital).
• The annual report contains both mandated financial
statements and voluntary disclosure.
• Information outside the financial statements is not
audited.
• 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 used to report activities excluded by
accounting standards from the financial
statements.
• Impression management used to improve
corporate image.
• Can be biased, even misleading.
 Electronic Reporting
• Using websites and blogs.
• Both financial and non-financial information is
disclosed on reporting entities’ websites.
• Only some, or none, of this may be audited.
• The IASB has developed a code of conduct for
Internet reporting.
– Boundaries of reports should be clear.
– Content of should be the same as the paper-based
reports.
– Reports should be complete, clearly dated and timely.
– Information should be user friendly and downloadable.
 Electronic reporting
• Extensible Business Reporting Language (XBRL)
• XBRL is a language for electronic communication
of financial data.
• XBRL is a computer-based language that converts
business and financial data to a standardized form.
– It standardises presentation.
– It makes possible continuous disclosure by reporting
entities.
– It offers cost savings.
– It improves efficiency, accuracy and reliability.
 Electronic reporting
What are the advantages of XBRL ?
• Consistency
• Comparability
• Transparency
• Financial data easily accessible
• Cost savings
• Analyzable
 Why Entities
Voluntarily Disclose
• Mandated accounting information is constrained.
• Variety of information is necessary to satisfy and
inform range of stakeholders.
• Reporting entities engage in activities that are
not captured in the reporting process. For
example, social and environmental activities.
• Reporting of Intangibles is restricted by
accounting standards so that many intangibles
are not included in financial statements.
• Organisations require and desire broad support.
 Management Motivation
to Disclose
• Deegan lists reasons for voluntarily disclosure
1. To comply with legal requirements
2. Because of accountability to stakeholders
3. Because of borrowing requirements
4. To comply with community expectations
5. To comply with industry requirements
6. To win reporting awards
7. To prevent threats to organisational legitimacy
 Management Motivation
to Disclose
• O’Donovan’s research suggests that
management discloses environmental
information to:
1. Align management’s values with social
values
2. Improve corporate reputations
3. Demonstrate strong management principles
4. Demonstrate social responsibilities
 Research into Annual Reports
• The theoretical basis for voluntary disclosure
is based on corporate social responsibility
(CSR), which aims to identify the motivation
for companies to make voluntary disclosure
about nonfinancial information.
• CRS: a way for companies to take
responsibility for the social and environmental
impacts of their business operations.
 Research into Annual Reports
• The most common theories about why
management would want to disclose its
actions in annual reports are:
I. Accountability Theory.
II. Legitimacy Theory.
III. Stakeholder theory
 Research into Annual Reports
• Accountability: an individual, or organization, being
answerable to the public or a higher authority for actions
taken and for the handling of resources received.
• Two of the main reasons for the increased demand for
accountability include
(a) the need to prevent fraud .
(b) maintaining public trust.
• Accountability Theory
– Accountability Theory involves monitoring, evaluation, and
control of organisational agents
– Accountability Theory focuses upon the relationship
between the corporation and users of its annual reports.
 Research into Annual Reports
• Legitimacy Theory
– Legitimacy Theory assumes a social contract
between society and the organization, using
annual report as a tool in which management can
demonstrate its fulfilment of its obligations to
meet community values.
• Stakeholder theory
– Management the relationship between
stakeholders about entity activities through means
such as the annual report
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