Financial statements: Future cash flows

The literature review will divided into two parts: theoretical review and empirical review. The former will consist of relevant literature from accounting frameworks and main definition from authors. Empirical review will comprise of evidence based from surveys and observations from scholars and researchers.

Theoretical Review

The main idea of financial reporting is to provide high-quality financial reporting information concerning economic entities, primarily financial in nature, useful for economic decision making. Information should be understandable by users who have a reasonable knowledge of business and economic activities and accounting and who are willing to study the information with reasonable diligence (IASB, 2007). This indeed highlights the technical aspect of financial reports. It is expected that financial reports are understood by users with rational accounting know-how. They are not intended for the laymen. Yet, this is a two-way traffic. The information presented to the informed reader should also be in a way that can be easily digested.

However, are annual reports not too ambiguous? As Zebda (1991, p. 119) explains: “An examination of statements, terms, and rules frequently used by accountants reveals that ambiguity exists in many accounting problems”. And this happens ”in spite of the ambiguity displayed in the accounting environment and the wide recognition thereof”. More recently, members express concerns about the level of complexity in the disclosures in financial statements (CIMA, 2009). Complexity renders information vague and is therefore of little use even to the informed reader. PricewaterhouseCoopers (2006) says that many of its clients are concerned that International Financial Reporting Standards (IFRS) have overcomplicated accounting and made it difficult for shareholders and analysts to interpret company performance.

Objectives of Financial Statements

In the past, the main purpose of financial statements was to appraise stewardship- accountability of management for the resources entrusted to it. Financial statements should allow a user to make predictions of future cash flows, make comparisons with other companies and evaluate management’s performance (IASC, 1989). However, today emphasis is laid upon decision-usefulness. As the IASB/FASB (2005) proposed “stewardship plays a minor role in the objectives of financial reporting, and is subservient to the broader objective of decision-usefulness. Some might even argue that its inclusion is no longer necessary, that is, its inclusion in the existing framework is largely for historical reasons”.

However, David Myddelton (2004) argued: “All the standard setters seem to agree on “decision-usefulness to investors” as the essential basis of financial reporting. But I still prefer the traditional “stewardship” approach, as most accountants do. The fact is that accounts are not prospectuses, and fundamental analysis of accounts is not useful to investors in predicting future profits”. This stance is also in line with the Statement of Principles (1999): “The objective of financial statements is to provide information about the reporting entity’s financial performance and financial position that is useful to a wide range of users for assessing the stewardship of the entity’s management and for making economic decisions”.

This indeed highlights that users of financial statements have different expectations. As put forward by Rudkin (2007), “users are not a homogeneous group and the same information cannot equally satisfy them all as they have different financial skills, interests and purposes”. IASB (2007) has therefore decided that “the objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions”.

What are Qualitative Characteristics?

In order to fulfil objectivity and usefulness criteria, corporate reports should be relevant, understandable, reliable, complete, objective, timely and comparable (Corporate report, 1975). These characteristics are also in line with the Trueblood report(1973).

According to IASB (2007), qualitative characteristics are the attributes that make the information in financial statements useful to investors, creditors, and others. The Framework identifies four principal qualitative characteristics namely understandability, relevance, reliability and comparability.

The IASB gives more importance to relevance and reliability. This is in contrast with the FASB which puts understandability as the first qualitative characteristic for understanding financial information. It stresses on the fact that information should first be understandable to be useful. “Understandability of information is governed by a combination of user characteristics and characteristics inherent in the information, which is why understandability and other user-specific characteristics occupy a position in the hierarchy of qualities as a link between the characteristics of users (decision makers) and decision-specific qualities of information”- (FASB, 2008). This has been illustrated in Figure 1 below:

Source: FASB Statement of financial accounting concepts no 2. Qualitative Characteristics of Accounting Information. 2008.

Understandability

Information cannot be useful to decision makers who cannot understand it, even though it may otherwise be relevant to a decision and be reliable. However, understandability of information is related to the characteristics of the decision maker as well as the characteristics of the information itself and, therefore, understandability cannot be evaluated in overall terms but must be judged in relation to a specific class of decision makers (FASB, 2008) (SFAC No. 2).

Understandable financial accounting information presents data that can be understood by the users of the information and is expressed in a form and with terminology adapted to the users’ range of understanding (APB, 1970, par. 89) [1] . According to the Trueblood Report, 1973, p. 60: “A better understandability requires that the form of presentation of reports and classification of data used be unambiguous. Moreover, information can be expressed as simply as permitted by the nature and circumstances of what is being communicated.”

Relevance

The function of qualitative characteristics is to ensure the validity of information. Typically, it should be timely, have predictive value and provide useful feedback on past decisions. Information in financial statements is relevant when it influences the economic decisions of users do that both by (a) helping them evaluate past, present, or future events relating to an entity and by (b) confirming or correcting past evaluations they have made (IASB, 2007).

Reliability

Information should also represent what it claims to represent. “The information presented should be reliable in that users should be able to assess what degree of confidence may be reposed in it” (Corporate Report 1975, par.3.6). It should be verifiable and another person should be able to recreate the reported value using the same information that the reporting entity has used. IASB (2007) stipulates that “information in financial statements is reliable if it is free from material error and bias and can be depended upon by users to represent events and transactions faithfully”.

Comparability

It should also ensure comparability over time and competing interests. In order to make valid inter-company comparisons of performance and trends, investment decision makers must be supplied with relevant and reliable data that have been standardised (Elliott & Elliott, 2006). Users must be able to compare the financial statements of an entity over time so that they can identify trends in its financial position and performance. Users must also be able to compare the financial statements of different entities. Disclosure of accounting policies is important for comparability (IASB, 2007)

Problems with current objectives

The IASB framework (2007) notes that financial statements cannot provide all the information that users may need to make economic decisions. For one thing, financial statements show the financial effects of past events and transactions, whereas the decisions that most users of financial statements have to make relate to the future. Further, financial statements provide only a limited amount of the non-financial information needed by users of financial statements.

Secondly, it is pointed out that the decision usefulness approach lacks poise in the framework. As the Basel Committee on Banking Supervision (2006) voiced out: ” it focuses too heavily- if not exclusively- on the information useful for predicting cash based on existing assets and liabilities while placing insufficient emphasis on information useful in assessing how entity management has fulfilled its stewardship responsibilities

According to Whittington (2008): “There is certainly a wide range of users of ‘general purpose’ financial statements, and they have many needs in common, but some might feel that additionally fulfilling the legitimate needs of present shareholders in their special role as proprietors is a necessary requirement, whereas other users have a less compelling claim”.

Furthermore, FASC (2007) put forward: “The primary use of information in financial reports is for investment decisions (equity and debt); stewardship is mentioned but almost in passing. The definition in the FASB framework reveals the strong bias towards investment decisions and neglect decisions related to stewardship. Almost disregarded is the information about how managers have used and possibly misused other enterprise assets … and examination and reports of the effects of conflicts of interest between their interest and interest if owners.

Users of financial statements

Each standard-setter has classified users of annual reports into diverse groups in order to make the distinction among their different needs and interests. This is depicted in the table below:-

ASSC- UK Corporate Report

FASB-US

IASB Framework

Equity Investor Group

Investors

Present and Potential investors

Loan Creditor Group

Lenders, Suppliers and other Trade creditors

Lenders, Suppliers and other Trade creditors

Employee Group

Employees

Employees

Analyst-Advisor Group

–

–

Business contact Group

Customers

Customers

Government

Government and their agencies

Government and their agencies

Public

Public

General Public

Source: Corporate report, FASB, IASB

Present and Potential Individual and institutional investors

The framework stipulates that because investors are providers of risk capital to the entity, financial statements that meet their needs will also meet most of the general financial information needs of other users. For the purpose of this report, individual and institutional investors will simply be denoted as investors or shareholders. They pay attention to information that will be useful in assessing how management has performed their roles efficiently. The Statement of Principles (1999) stressed out on their interests on the risks associated with their provision of capital. “They are concerned with the risk inherent in, and return provided by, their investments and need information in the entity’s financial performance and financial position that helps them to assess its cash generation abilities and its financial adaptability”.

Employees

Employees and their respective groups are concerned with information about the stability and prosperity of their employers. They are also interested in ensuring that the company is able to keep on operating, so, maintaining their jobs and paying them acceptable wages, and that any pension contributions are maintained. (Frank wood. 2004, p.137). They may be more focused on items such as retirement benefit obligations, borrowings and profits generated from operations.

Lenders, Suppliers and Trade Creditors

Lenders, Suppliers and Trade Creditors are mainly interested with information about whether the reporting entity has the ability to repay back sums and interest that are connected to them. The main difference among them is that lenders tend to focus over a longer period than the two other user groups. For instance, they may look at capital structure ratios, such as gearing ratio as compared to suppliers and trade creditors which may be interested with liquidity ratios.

Financial analysts

According to Schipper (1993), the analyst’s job is to provide buy-sell-hold recommendations and research reports to support those recommendations. They research macroeconomic and microeconomic conditions along with the company fundamentals to support those recommendations. An analyst must be aware of current developments in the field in which he or she specialises as well as in preparing financial models to predict future economic conditions for any number of variables (Granville, 2009). All users of accounts, may, but do not necessarily require the skills requires to analyse financial statements. Yet, the core part of the analyst’s job is analysing corporate annual reports. They are employed mainly banks, insurance companies and pension funds to help these companies or their clients make investment decisions.

Trade-off between Qualitative Characteristics.

Reliability and relevance may often have conflicting interests, requiring a trade-off between them. Although financial information must be both relevant and reliable to be useful, information

may possess both characteristics to varying degrees. It may be possible to trade relevance for reliability or vice versa (FASB, 2008) (SFAC No 2, par 42). This trade-off is further highlighted in the statement (par. 90): “Reliability and relevance often impinge on each other. Reliability may suffer when an accounting method is changed to gain relevance, and vice versa. Sometimes it may not be clear whether there has been a loss or gain either of relevance or reliability”.

Interactions between these highest qualitative characteristics show accounting’s “ambiguity-creating” capacities (Reinstein et al, 2007). It may not always be possible to present a piece of relevant, reliable and comparable information in a way that can be understood by all the users with the capabilities. However, information that is relevant and reliable should not be excluded from the financial statements simply because it is too difficult for some users to understand (Stein, 2000). Ernst and young (2005) further proposed that financial reporting governance can only be exercised properly if adequate weight is given in the setting of accounting standards to all of the four attributes that make the information in financial statements useful to users, i.e. understandability, relevance, reliability, and comparability.

Empirical Evidence

In their respective studies, Epstein and Pava (1993) and Chang and Most (1977) found that the annual financial reports were the most important source of information. While taking the responses of 374 individual investors of a large British company, Lee and Tweedie (1975) found that the profit and loss account was regarded as the most important report. Similarly, Lawrence and Kercsmar (1999) reported that investors frequently used income statement figures for the purpose of investment decisions.

Baker and Haslem (1973) found out that the majority of the individual investors rely heavily on stockbroker’s advice in the United States. Financial statements, were found to be a source of information by only a minority (i.e., 8 per cent) of individual investors. They also highlighted that individual investors attach a great deal of importance to the information about the future expectations of the company. Additionally, Bird et al. (2001) reported that accounting information helps in predicting future earnings in Australia and the UK.

Considerable empirical evidence has been documented showing that firm characteristics – such as size, leverage, earnings-to-price ratios, book-to-market ratios, among others – are associated with stock returns (Penman, 1998). These results are echoed by those reported by Thinggaard and Damkier (2008), which showed that the contents of financial statements can explain the variation of stock market returns in Demark. Francis and Shipper (1999) reported a decreasing trend in the value-relevance of financial statement information in the U.S. over the past decades. Yet, this is in contrast with the results of Chen et al. (2001, p. 18) who later found that “accounting information is value-relevant in the Chinese markets”.

In developing countries, Abu-Nassar and Rutherford (1996) and Abdelsalam (1990) undertook a study in Jordan and Saudi Arabia respectively. The first mentioned documented the low degree of users’ satisfaction about many qualitative characteristics of corporate reports in Jordan. Focussing on what is important to Saudi investors, Abdelsalam (1990) highlighted that it is information about the future of the company as well as information about directors.

How to measure and increase understandability?

Understandability is measured using five items that emphasise the transparency and clearness of the information presented in annual reports. First, classified and characterised information refers to how well-organised the information in the annual report is presented. If the annual report is well-organized it is easier to understand where to search for specific information (Jonas & Blanchet, 2000). Furthermore, disclosure information, and in particular the notes to the balance sheet and income statement, may be valuable in terms of explaining and providing more insight into earnings figures (Beretta & Bozzolan, 2004).

The presence of tabular or graphic formats may improve understandability by clarifying relationships and ensuring conciseness (Jonas & Blanchet, 2000). Moreover, if the preparer of the annual report combines words and sentences that are easy to understand, the reader will be more likely to understand the content as well (Courtis, 2005). If technical terminology is unavoidable, for instance industry-related jargon, an explanation in a glossary may increase the understandability of the information. Furthermore, Shohaieb (1980, p.54) put forward: “A better understandability requires that information should at least to some extent, be comparable with similar information and the message(s) being communicated should be comprehensible”.

Factors affecting understandability

Issues that affect understandability directly relate to ambiguity in the financial statements. Norton (1975, p. 608) defined ambiguity as “information marked by vague, incomplete, fragmented, multiple, probable, unstructured, uncertain, inconsistent, contrary, contradictory, or unclear meanings as actual or potential sources of psychological discomfort or threat”. According to Zebda (1991), the definitions of ambiguity, “all emphasize the basic idea of imprecision and inexactness”. It is the imprecision and inexactness that creates the need for judgment in accounting environments. This can be buttressed with the statement of Gibbins and Mason (1988) who observed that “the exercise of professional judgment by those preparing and auditing financial accounting information is at the core of financial reporting”.

Standard overload

Cook and Sutton (1995) stresses on the fact that companies should focus on the information requirements of shareholders so that the annual report satisfies their needs. Preparing summary annual reports rather than engaging into information overload by providing a detailed annual report can satisfy their needs. The term “standards overload” is one that has been used off and on over the years by the FASB’s various constituent groups to describe their concerns about not only the volume of accounting rules and the level of complexity and detail of those rules, but also the resulting profusion of footnote disclosures and the difficulty of finding all the accounting rules on a particular subject. (FASB, 2002) [2] 

Elliott and Elliott (2006) put forward several points to describe standard overload. This may also be viewed as a reflection of annual reports under IAS/IFRS or the US GAAP. For instance:

There are too many standards.

Standards are too detailed.

Standards are general purpose and fail to recognize the differences between large and small entities and interim and final accounts.

There are too many different standard setters with different requirements e.g, FASB, IASB, national standard setters, national stock exchange requirements.

Conceptual understanding of key terms

An important criterion for usefulness is proper definition of important terms in the financial statements. This is done through the framework. It attempts to give a give a succinct definition to the elements of the financial statements namely assets, liabilities, equity, income and expenses. Baker (2010) has evidenced that basic accounting terms have serious loopholes in definition. For instance, he points out that “it is surprising, given that the IASB framework is so important yet also in essence very simple, that it appears to have passed unnoticed that the definitions of income and expenses are in conflict with the basic principles of double-entry accounting. It is not simply that they are not worded as tightly as they might be, but rather that they fail to recognise the distinction between a debit and a credit”.

The author also evidenced that: “The Framework, which is central to financial reporting under IFRS, incorrectly defines two of the five elements in the financial statements: income and expenses. These are defined as changes in assets, rather than as their counterpart, changes in equity. It is unsatisfactory for a conceptual framework to be conceptually flawed in this way. Profit is not a change in assets: that is not the way double-entry accounting works”.

Frequency, volume and complexity of amendments to standards

Furthermore, it could be added that the frequency that standards are being revised makes it thorny for users to keep abreast to it. According to the UN Report (2006) [3] : “it has been a very challenging time for preparers, auditors and users of financial statements, following the publication of new and revised IFRS’s. The following evidences the frequency, volume and complexity of the changes to international standards:

The IASB’s improvements project has resulted in 13 standards being amended, as well as consequential amendments to many others.

Repeated changes of the same standards, including changes reversing IASB’s previous stands and changes for the purpose of international convergence.

Complex changes on accounting standards, such as those on financial instruments, impairment of assets and employee benefits require upgrading of the skills of those professionals who implement them, in order to keep up with the changes”.

Narrative notes to the accounts

Narrative explanations help to increase the understandability of information (Iu & Clowes, 2004). Survey evidence such as Chang et al (1983) and Lee and Tweedie (1975) suggest that unsophisticated users of annual reports tend to rely mostly on financial narratives. However, Jones and Shoemaker (1994) showed that accounting narratives are difficult to read. In a more recent study by ACCA, CFO, UK (2010) [4] highlights that “narrative disclosures are generally improving in quality, but too much volume and regulation are making documents bulkier, making it harder for the reader to see the wood for the trees. We would encourage a reduction in the amount of information and required disclosures”.

Fair value accounting

Laux and Leux (2009) put forward that FAS 157 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date” (Laux and Leuz, 2009). It is hard to argue that fair value is not a relevant measure. Financial statements based on fair value measurements useful, more accurately reflect real-world volatility, simplify financial reporting and are more understandable and comparable to other financial statements (Ferguson, 2008). However, other aspects of financial reporting are just as- and perhaps more- important: reliability, understandability and comparability. Opponents claim that fair value is not relevant and potentially misleading for assets that are held for a long period and, in particular, to maturity; that prices could be distorted by market inefficiencies, investor irrationality or liquidity problems; that fair values based on models are not reliable. (Laux and Leuz, 2009)

Measurement issue

IFRS has opened up certain choices that an organisation will have in how to measure some items giving rise to different measurement models. For instance, the cost model or the revaluation model can be used under IAS 16 (Property, plant and equipment). Not only is use of multiple measurement bases conceptually unappealing, “it makes it difficult for financial statement users to separate accounting-induced income or expense from economic income or expense” (Barth, 2006). Measuring financial statement amounts in different ways complicates the interpretation of accounting summary amounts such as net income.

Improvement to annual reports

The AICPA (1994) formed a Special Committee on Financial Reporting to tackle issues about the relevance and usefulness of business reporting. The Committee carried out a study over a three year period and came out with the following recommendations [5] :

Provide more information about plans, opportunities, risks and uncertainties;

Standard-setters should work to improve understanding of costs and benefits of business reporting, recognizing that definitive quantification of costs and benefits is not possible.

Improve disclosure of business segment information.

Improve disclosures about the uncertainty of measurements of certain assets and liabilities.

Improve quarterly reporting by reporting on the fourth quarter separately and including business segment data.

The report has also envisioned that standard-setters should adopt a longer-term focus rather than engaging on day-to-day issues by developing a vision of the future business environment and users’ needs for information in that environment. “Standards should be consistent directionally with that long-term vision” (AICPA, 1994).

This student written literature review is published as an example. See How to Write a Literature Review on our sister site UKDiss.com for a writing guide.