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AYB311 W8 L.docx

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WEEK 8 – PRODUCTS OF FINANCIAL REPORTING Content of Annual Reports ‘Annual report’ documents include:  Financial report o Financial statements  Income statement  Balance sheet  Statement of Changes in Equity  Cash flow statement o Notes to the financial statements  Most of the useful information about the figures can be found in this section o Directors’ declaration  Directors’ report o From July 2004 must include an operating & financial review  Auditor’s report True and Fair View  Financial reports are subject to a true and fair test o Means in accordance with the facts & free from bias but is not specifically defined  Do the two terms mean the same thing?  Two people can give two different accounts of the same event – people bring bias into every decision made o Generally assumed to mean compliance with the ‘substance’ of GAAP  Corporations Act (2001) provides this is not a correct approach. If you have not, then it is necessary for the entity to add further information o If necessary, information must be added to notes to ensure a true & fair view o This is provided in the Corporations Act (2001) Limitations of Financial Reporting  Retrospective focus o Not exactly a criticism, it provides useful information but it is a limitation on the decision usefulness of the information o Historical information provides a lot about what happens in the past and is very reliable  Some argue we need more forward looking information to improve decision usefulness  Historical = more reliability but less relevance  Understandability o There is a difference between doing something and understanding it o Is the information provided understandable for users? o If the information provided is not understandable, then it is not useful.  Lack of timeliness o By the time the information is released, it has been long out-dated information (it can often taken 3 months for financial reports to be released)  Alleged manipulation of reported earnings  Exclusion of certain activities form the financial reporting process o Last two are most important and will be covered in a lot more depth in the lecture later Alleged Manipulation of Reported Earnings  The need to choose arises from three causes o Some areas are still not covered by specific accounting standards o Even when there are accounting standards they may contain alternative policies  For example, PPE standard provides you can use different models of measurement – the option chosen will impact the balance sheet / income statement o Accountants are required to make judgements on various estimates  Doubtful debts and depreciation both require a judgement  Accountants make the decision about difficult situations ie. Measurement at fair value or cost Creative Accounting  Using accounting methods that ensure financial reports present the preparers’ desired view of the state of affairs of the entity  The preparer is ensuring they are putting their ‘best foot forward’ ie. Showing all their best attributes  Most ‘creative’ techniques are within the constraints of accounting standards  Has a general negative perception amongst most people Creative ways of preparing financial reports  Choosing an accounting method or changing accounting methods to achieve a desired outcome  Making biased estimates or predictions of future events  Disclosing information in a way that influences users’ interpretations  The income statement requires 10 items to be included on the statement. If the income statement requires 30 items, it is highly unlikely to be read. This is a way in which information can be hidden in the assumption that people will not read the information.  Timing transactions for particular reporting periods Earnings Management  A form of creative accounting  Incentives to manage earnings o Contracting o Market-based  Types of earnings management o “Real” earnings management  Investing and financing decision o Discrete method choice o Accruals manipulation o Manipulate disclosures Patterns of Earnings Management  Take a bath o during periods of organisational stress, reorganisation, hiring new CEO  Income minimisation o e.g. reduce political visibility  Income maximisation o e.g. in presence of bonus plans; firms close to breaching debt covenants  Income smoothing o reduce volatility in earnings Proforma reports: massaging earnings  More of a gradual process in which statements are produced at an early statement than normal and in a shorter form than usual knowing that the information contains some estimates. The company may do this if they are expecting losses  Pro-forma results o Financial statements for a period prepared before the end of the period which therefore contain estimates  Pro-forma reporting o Bhattacharya et al (2004) found  Is used by less profitable firms with higher debt than other firms in their industry  These firms are more likely to release the pro-forma reports when their share price and earnings decline Exclusion of Activities from the Financial Reporting Process  Management can manipulate o with approved methods of accounting for certain activities or o exclude expenses to massage their earnings  this may be part of the accounting regulations  Firms make voluntary disclosures Intangibles  Physical assets in balance sheets is quite different to intangibles.  Traditional accounting o Not able to provide information about corporate intangible assets  Investment by global manufacturers o Equal to total investment o Research cannot be listed on the balance sheet  Treatment of intangibles o Expectation of future benefits  Do you assume brands are not going to provide future benefits to the entity even though they are no longer listed by still prove profitable? Intellectual Capital  An umbrella term encompassing capital created by employees (such as patents) o Relationships with customers and suppliers (such as brands, trademarks) o Capital invested in employees (such as in training or education) Responses to criticisms/limitations of financial reporting  Retrospective focus o Disclosure of future-oriented information o Financial forecasts have the potential to significantly expand the market’s information set o In the US the AICPA provides guidelines  Similar guidelines are non-existent in Australia o Problems include:  the reliance on assumptions  the form, horizon, verification method, and legal implications  Understandability o Management Discussion and Analysis statements  Some future looking information but not much  Information that is reasonably required  No specific format required o Concise Financial Reporting  Criticisms of usefulness and increasing costs of annual reports  Corporations Act allows entities to send a concise financial report to members consisting of:  Concise financial report in accordance with accounting standards  Directors’ report for the year  Statement by the auditor o That the financial report has been audited o Whether, in the auditor’s opinion, the concise financial report complies with accounting standards o Copy of any qualification and any emphasis of matter in the auditor’s report o Do not have to include the auditor’s full report unless there was a problem fou
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