The Role of Financial Reporting

How does financial reporting information fit into business? Financial reporting ultimately serves a number of different desired outcomes. One of these is economic growth. It does not promote growth directly; instead, growth is promoted through a number of subordinate outcomes. One of these could be described as good business performance. This in turn is promoted through subordinate outcomes that could be described as good business decisions and good management. Financial reporting information is one type of information that helps people understand whether desired outcomes are being achieved. Have good decisions been made? Have they been well implemented? Have they led to good performance?

Good business decisions covers all business-related decisions by investors, lenders, managers, suppliers, customers, employees, and so on. The Role of Financial Reporting

  • Investors decide what actions to take regarding the management of the companies in which they invest, taking into account managers’ stewardship of the business, and whether to buy, hold or sell shares.
  • Lenders decide whether to lend, on what terms, and whether to enforce security.Good management
  • Managers take the strategic and day-to-day decisions that direct a business’s activities.
  • Suppliers decide whether to supply a particular customer and on what terms.
  • Customers decide whether to buy from a particular supplier and on what terms.
  • Employees decide whether to enter into and remain in employment with a particular employer and on what terms.

The groups whose decisions are assisted by financial reporting information are diverse, and they may therefore have different information needs. And it cannot be assumed that all the members of any one group, such as investors, will have similar information needs.

Good management, in the sense used here, refers to the implementation of decisions. Good decisions can be incompetently implemented, leading to poor performance. The consequences of poor decisions can be mitigated by skilled managers. The Role of Financial Reporting

Some business decisions are also determined, limited or activated by financial reporting information in accordance with previously agreed contracts or requirements. For example, in relation to managers’ pay, dividends, and lenders’ rights, financial reporting information automatically triggers or limits actions determined by previous decisions (embodied in the terms of the relevant contract or requirement). In these situations, outcomes will be poor if the financial reporting is poor.

Other public policy outcomes that are served by financial reporting include: The Role of Financial Reporting

  • The prevention of fraud. Financial reporting is a way of helping to ensure that, among other things, creditors’ and shareholders’ money has not been stolen.
  • Fairness among investors. If some investors in a company have more information than others, this can lead to unfairness.
  • Fairness in taxation. Fairness in taxation requires profit information that is comparable and checkable.
  • Protection of depositors. Regulators require information on banks’ financial health in order to protect depositors.
  • Protection of the insured. Regulators require information on insurers to protect the insured.
  • Protection of investors. Regulators require information on investment vehicles to protect investors.
  • Protection of consumers. Regulators who set service levels or limits to prices in industries where competition is restricted require information on the costs and income of regulated businesses.
  • Promotion of competition. Regulators require information on businesses to assess their profitability in different markets, and so do potential market entrants.

What are the mechanisms that public policy can draw on to secure the desired outcome of good financial reporting information?

  • Through requirements and prohibitions, laws and standards can lay down what information should be provided and how it should be prepared.
  • Through rating and benchmarking, external observers can rate the quality of information provided, encouraging companies to emulate one another.
  • Through voluntary codes, as are found in some specialised sectors, businesses can agree improvements and voluntary standards in reporting.
  • Through stakeholder engagement, investors and others can persuade businesses to improve their disclosures.
  • Through corporate policies, individual companies may decide that they will adopt improved disclosures, perhaps because they see advantages in greater transparency.

Approaching financial reporting measurement as a public policy issue has a number of implications.

These include: The Role of Financial Reporting

  • All the diverse public policy uses of financial reporting information should be taken into account, and decisions on measurement should be assessed in terms of their cost-effectiveness in contributing to the desired outcomes of public policy.
  • It should be assessed whether making and enforcing rules on measurement is always the most cost-effective way of achieving desired outcomes.
  • Desired outcomes are achieved by affecting behaviour. In assessing the probable and actual effects of measurement information, it is its impact on behaviour that counts. How people use information and respond to it are therefore critical issues. ‘A good standard or reform is one that works in practice and how it works in practice will depend on how managers and others use it.

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