Financial reporting - an evolutionary process

It is natural at a time of financial and economic crisis that reporting by entities should come under critical scrutiny. While it may be too early to make confident assessments of the role of financial reporting in the crisis, at present the charge that financial reporting either caused it or made it significantly worse has provoked strong debate over whether reporting weaknesses contributed to the financial crisis or failed to send warning signals to investors and other stakeholders in a timely manner.

Criticisms of financial reporting

Some of the criticisms that have been made about financial reporting include:

• Financial reporting is 'backward-looking' and does not serve the needs of the users who are usually interested in the future more than the past and call for business reporting to be more forward-looking
• Financial reporting focuses on monetary amounts and much of what investors and others want to know is qualitative - its strategy, for example, or the calibre of its management
• Financial reporting uses certain measurement models which many consider promote pro-cyclical behavior and may also give rise to unreliable values being included in financial statements, particularly when markets are relatively inactive
• Many investors want a better quality of non-financial quantitative information on such matters as customer satisfaction or sales volumes
• Many significant intangibles do not appear on corporate balance sheets which, in itself, may be perceived to be a problem and has been a major contributor to the gap between the balance sheet value of companies and their stock market value

The recent financial and economic crisis has eroded much of the underlying confidence of investors and other stakeholders in intangible values. However, the value of intangibles is not the only factor underlying the 'value gap', with investor confidence also being fuelled by a belief in the business models and success drivers of entities. Recent experience has shown that it is this often innate belief among the market community that drove stock market prices higher and higher and in many cases beyond a point of sustainability. The erosion of this confidence by the underlying global financial and economic difficulties, together with what many see as deficiencies in financial reporting and inadequacies in the reporting of the non-financial information, led to the inevitable collapse of stock market values.

In 2006, 'Global Capital and the Global Economy: A Vision from the CEO of the International Audit Networks' was published. This stated 'the larger discrepancies between the "book" values and "market" values of many, if not most, public companies, provide strong evidence of the limited usefulness of statements of assets and liabilities that are based on historical costs. Clearly, a range of "intangibles" that are not well measured, or not measured at all, under current accounting conventions are driving company performance.'

Similarly to a number of other reports published at or about this time, this message foretold difficulties the scale of which was probably not anticipated by many, if any, observers. While perceived as being a significant contributor to these difficulties it was not alone with, inter alia, practices adopted amongst the banking and financial sectors playing perhaps an even greater part.

Limitations may also be strengths

It should be borne in mind that aspects of the financial reporting process which are subject to criticism are in many ways fundamental strengths with key characteristics providing investor protection, which include:

• Historical - there is an objective record which does not depend on the ability to forecast the future and to that extent deliberate bias and managerial optimism can be guarded against
• Financial - financial reporting information emerges from a business's records of transactions with third parties, which relies on an accounting system that has to be in place for the business to function effectively
• Quantified - although some numbers in financial reports may be subjective, quantification can provide objectivity and the potential for verification

The inherent limitations of financial reporting are advantages in terms of the reliability, and even the relevance, of the information it provides. They provide it with a strong advantage by comparison with softer forms of information such as much qualitative, forward-looking and non-financial reporting.

Length and complexity - a solution?

Many criticise the length and complexity of financial reporting without perhaps taking full cognisance that it is the underlying demands of the markets it serves that cause it. A report published recently by the Institute of Chartered Accountants of Scotland - 'Making Corporate Reports Readable' - puts forward an interesting potential solution. This is in the form of a pro-forma short form report - which uses the example of a fictional universal bank as the underlying business - that produces in less than 30 pages the key information of interest to investors, including the most important aspects of past performance and future strategy. The objective is to provide a definitive, uncluttered statement of how the business makes its money and top management's view on the business model. This would, it proposes, be published and made available by companies at the same time as the full-length annual report.

Global perspective

The International Federation of Accountants (IFAC) recently published its 2009 Global Leadership Survey, based on a poll of its membership of 157 accounting organisations in 123 countries. The survey cited as the top priorities of the accountancy profession's leadership:

• Increase confidence in international standards for accounting and auditing, in both the private and public sector
• Adopt and implement international standards, including principles of good corporate governance
• Urge the G-20 to not place unreasonable burdens on small and medium sized enterprises through new regulations or re-regulation

The IFAC CEO commented - 'to move beyond the current crisis and ensure protection of all investors and taxpayers, the necessary parties around the world need to adopt and implement high-quality global standards'.

At a recent meeting of the European Parliament's Special Committee on Financial, Economic and Social Crisis (CRIS) a number of issues were discussed amongst which were to emphasise the G-20's demand to work towards convergence of different accounting systems in order to have standards that 'truly fit the system'. It was stressed that there is a need for accounting standards to take account of the real risks in financial and economic markets with the concern reported that 'un-transparent and insufficiently harmonised accounting standards had also led to pro-cyclical behaviour'.

In the U.S., the Securities and Exchange Commission (SEC) has also expressed its support and commitment to global convergence of standards provided development of certain standards takes place, with a timeline of June 2011, and other key milestones are achieved.

While global convergence of standards is seen by most to be the key driver at this time, the question that many continue to ask in the light of market chaos may be 'is the accounting model broken - or is it more a case that some features of current practices could be usefully improved?'. Proponents of the first scenario are in danger of 'throwing the baby out with the bathwater' and the question must be asked is accounting a model based process where one model can be discarded to be replaced by another or is it a practice that needs to evolve in a constantly changing environment, responding to changes in business, in information technology and in users' needs? Various forces - market needs, regulatory requirements and others - all push business reporting to adapt to changing circumstances and as it will always be controversial in some manner there will always be a degree of dissatisfaction with it. But there are grounds for optimism that it may be seen to be reasonably well adapted to users' needs and, as long as it continues to evolve, it should remain so in the future. Sometimes there may be a call for more radical change but even in those circumstances to conclude that 'the reporting model is broken' is most likely to be wide of the mark. The evolutionary process must continue and proposals for reform must be considered on their individual merits.

First published in Finance Dublin online