Understanding Financial Reporting
Financial reports allow the organization to communicate information about their performance to the “outside world”.So, financial reports provide summarized information about an organization”s transactions for external decision makers.(e.
g. Investors). Financial reports can be used by employees and trade unions, government, creditors and lenders, customers, shareholders and investment analysts. All these users may need different statements of financial accounts but the most important statements which they need is the balance sheet, profit and loss account, cash flow account and the income statement.
The two main regulatory bodies of financial reporting are the “Law” and the “Accounting Profession” with the Accounting Standards Board usually known as ASB. In UK, most of the legislation related to the publishing of accounts is embodied in the Companies Act 1985 and 1989 which are concerned with the accounts of the limited liability companies only. The Companies Act 1989 is the main frame which the companies and accountants have to follow. All the financial statement drawn up under the act 1989 must present a true and fair view and its function is to protect all the users of the financial reports and statements.
The second and the most important regulatory body is the accounting profession. The standard setters should be aware of the information needed by all users of financial reports and should know the impact and the outcome of a different accounting method on the needs of those users. The standard setters should also be able to resolve the conflicts which exist between the needs of different users. So, they have to find an alternative way which best satisfy user needs and this could be achieved by choosing the improvement of the “social welfare” instead of welfare of individuals.
We know that Accounting Standards Board is the main accounting standard setter. Because the ASB is composed of professional accountants, they may be unfamiliar with the user needs. So , when there is a need for a change in accounting standard the ASB prepare and publish a draft standard called the FRED (Financial Reporting Exposure Draft). After the publishing of these drafts the comments from the public is invited and in the light of these comments the FRED is changed (or unchanged). Now the FREDs are issued as FRS (Financial Reporting Standard).
The main disadvantage of this system is the ASB members are unfamiliar with the different user needs and the comments from the general public may not be equally represented. There are four things that standards in financial reporting supply people using it. The first one is “Comparability”; financial statements must allow people to compare one company with another one and evaluate the management”s performance without spending time and money adjusting them to a common format and common accounting treatments.
It is essential that users of financial reports or investment decision makers be supplied with relevant and standard financial reports which have been regulated and hence standardized. The second thing that standards and regulations supply is called “Credibility”. Because all this standards and regulations exist accountants have to treat every company in the same way. If the accountancy profession permitted companies experiencing similar events to produce financial reports that disclosed markedly different results simply because of a freedom to select different accounting policies they would lose all of their credibility.
So, the standards should be composed of rigid rules and should not be broken. The third thing is “Influence” that means, setting up the standards has encouraged a constructive appraisal of the policies being proposed for individual reporting problems and has been a stimulus for the development of a conceptual framework. The last thing that the standards have to supply is “discipline”. Companies left to their own devises without the need to obey standards will eventually be disciplined by the financial markets.
But in the short run investors in such companies may suffer loss. The Financial Reporting Council is aware of the need to impose discipline because most of the company failures in recent years are because of obscure financial reporting. Why should the Accounting Standards set? As we argued before, an important role of the regulations is to increase the comparability of accounts by limiting the choice of alternative accounting methods and to supply standardized accounts.
This standardization can be achieved only by uniform accounting practice. If all accounting methods were standardized, two organizations which began the year with same balance sheets and which made the same transactions during the year, they would report the same balance sheets and the same profit and loss account at the end of the year. In addition to these advantages of regulations in financial reporting, there are also some more useful functions.
Regulations can help to reduce the influence of personal biases and political pressures on accounting judgments. They can increase the level of user confidence in, and understanding of, financial reporting by clarifying the basis on which all accounts are prepared and presented. Finally, they can provide a frame of reference for resolving accounting problems which are not mentioned in legislation or accounting standards. As we argued earlier although the regulations in financial reports have very advantages it has many disadvantages too:
One if these disadvantages is the “Adverse Allocative Effects”, this could occur if the ASB did not take into account of the economic consequences of the new standard or regulation they have issued. For example, additional costs could be imposed on preparers of accounts and suboptimal managerial decisions might be taken to avoid any reduction in earning or net assets. “Consensus-seeking” can be another disadvantage and this means the issuing of standards that are over-influenced by those with easiest access to the standard-setters. Most of the time this could happen with complex subjects.