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Home > Auditing Best Practice > Effective Financial Reporting and Auditing: Importance and Limitations

Auditing Best Practice

Effective Financial Reporting and Auditing: Importance and Limitations

by Andrew Higson

Executive 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 they can produce consistent and coherent standards), users (so they understand the nature and scope of financial reporting), external auditors (so they can say whether the financial statements are “fit for purpose”), 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 financial reporting expectations gap.

  • Perceived defects in financial statements have resulted in a call for real-time financial reporting, but this may have the effect of creating more volatility in share price movements.

 

Introduction

The major problem with financial reporting is that people with limited financial knowledge can look at a set of accounts and, by attempting to interpret the numbers, feel that they understand what is happening in an organization. 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 statements may 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 statements problematic to say the least. In the past accounting was defined as “an art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character, and interpreting the results thereof.”1 The need for financial reporting came about with the development of permanently invested capital (today’s share capital), which required a return to be made to the shareholders for their investment over a period of time (usually annually). The separation of ownership and management, especially in larger organizations, gave rise to the need for the accountability of the managers (agents) to the owners (principals), the financial statements being a convenient basis for this. In some jurisdictions financial statements also form a basis for the calculation of taxation. 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 never intended.

Decision-Usefulness

Since the 1960s, the function of accounting has been increasingly regarded as “to provide quantitative information primarily financial in nature about economic entities that is intended to be useful in making economic decisions, in making resolved choices among alternative courses of action,”2 and accounting was seen as a service activity.

On a simplistic level, the decision-usefulness approach may be intuitively appealing, but it could also be conceptually flawed and an example of circular reasoning: just because some people may take decisions based on the financial statements, does this mean that decision-usefulness should be specified as the objective of financial statements? When one takes a decision, one should be looking to the future—yet the financial statements say very little about an organization’s future. One should also consider the future economic climate, an organization’s competitors, and expected technological developments; financial statements say very little about these things. Often short-term investors are more concerned about taking their decision in anticipation (buy long, sell short) of the publication of the financial statements rather than waiting 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 of the nature, scope and purpose of accounting “theory.” One would have expected developments in financial reporting to have been built on theory and thus be conceptually robust. The focus on unspecified users taking unspecified decisions, at unspecified times, with unspecified results hardly seems an appropriate basis for the production of consistent and coherent financial reporting standards, and consequently there is a danger that the financial reporting standard-setters have been building on shifting sands rather than on firm foundations.

The Call for Real-Time Reporting

Given the prevailing emphasis on decision-usefulness, and the perceived limitations of financial statements in this respect, some analysts and other external parties have been calling for companies to make real-time accounting 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 results on a minute-by-minute basis rather than just putting the annual accounts on the internet), would the results make 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 in order to keep track of the transactions undertaken by an organization—which is obviously very important for management to do. The periodic financial statements use these accounting data, and related assumptions and conventions, to allocate profit to the appropriate accounting period and to present the financial figures at a point in time (this is after the necessary cut-off adjustments and checks have been made). Given the scale of 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 it would lead to greater market efficiency. Indeed, instantaneous access to real-time accounting data may not necessarily result in greater market efficiency—though greater volatility in share price movements would be a distinctly possible consequence.

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Further reading

Books:

  • 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.

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