What does Financial Reporting mean?
Financial reporting has a broader scope than just reporting information through income statements, balance sheets, authoritative pronouncements, and regulatory rules. It means reporting consists of not only monetary information but also non-monetary information.
Financial reporting does not mean reporting information only through income statement (profit and loss account) and balance sheet. If major and crucial information is communicated through financial statements, then the justification for this crucial information is communicated through schedules and guiding notes, so that the ‘reporting information becomes authentic and clear’. The basic objective of reporting information is that any person (internal or external) using this information be guided properly when making a decision based on his/her requirement.
Definition by AICPA
Financial reporting is defined by AICPA as ‘communication of published financial statements and related information from a business enterprise to third parties (external users) including shareholders, creditors, customers, governmental authorities, regulatory bodies and the public. It is the reporting of accounting information of a business entity (individual, firm, company, government enterprise) to a user or group of users. This definition connotes that financial reporting has a broader scope than financial statements. An enterprise communicates information to users (both internal and external) through financial statements and other substantiating details through schedules, guidance notes, etc., because the information is either required to be disclosed by authoritative pronouncement, regulatory rule, as a custom/tradition or the enterprise deems it necessary to disclose the same voluntarily.
However, reporting information is expected to cover not only monetary information but also non-monetary information relating to contributing towards social and environmental causes connected with social responsibility.
For example, if a hospital is built to provide free health care facilities to the public, the cost of construction and the expenses incurred to maintain the same forms monetary information, whereas the number of people getting free health care services to become non-monetary information. In fact, decision-makers do not depend purely on monetary information but also consider the non-monetary information to make a better decision.
Objectives of Financial Reporting
Financial reporting should be done in such a way that the reported information is realisticæ amenable for interpretation and help the investors to make proper investment decisions.
Financial reporting should satisfy at least two basic objectives:
- The information reported should help the users to make investment decisions.
- The information reported should provide information to the users to judge the effectiveness of the enterprise.
These two points are discussed in the following paragraphs.
- To help make investment decisions: Investors are interested in such investments that provide them the greatest total return in the form of either interest or dividend with an acceptable range of risk. Further, they expect capital appreciation also at least over a reasonable period of time. While making investment decisions, the investors assess an enterprise’s future earnings power in order to estimate their future cash return in the form of dividends and capital appreciation. The business information relating to earnings power is assessed on the basis of continuous earnings from operating assets over a reasonable period of time (say three years, five years, etc.). Investors compare returns on alternative investments based on risk-return viability. Therefore, the reported information should be realistic’ amenable for interpretation and help the investors to make proper investment decisions.
- To judge the effectiveness of management: The reported financial information —should provide an individual the opportunity to judge the effectiveness of the management of an enterprise on the basis of (1) safekeeping of the resources and their custody; (2) efficient and profitable use of the resources; (3) future developmental plans; and (4) measures undertaken to avert the adverse impact on the enterprise due to changes in technology, price level (inflation, deflation or recession), etc. In addition, a management’s effectiveness depends on information transparency and accountability. It is the accountability that decides the effectiveness of the enterprise.
Therefore, the reported financial information should be able to project a realistic view of the enterprise.
If we observe the historical development of financial reporting, we would see that many accounting bodies and professional institutes from all over the world have contributed to reporting information, to make it user-friendly, taking into consideration the changing needs of the users of information.
In this regard, the objectives of reporting financial information have been increasing by leaps and bounds day by day. Here we highlight the objectives (of reporting information) developed by the American study group, appointed by AICPA in 1971 and lead by chairman Robert. M. True blood. The study group, submitted its report in October 1973. The objectives as developed by the study group are summarized as follows:
- To provide information that is useful for making economic decisions.
- To serve primarily the users who have limited authority, ability or resources to obtain information relating to the economic activities of the enterprise.
- To provide information that is useful to investors and creditors about the potential cash flow of the enterprise to make decisions.
- To provide users with information for predicting, comparing, and evaluating an enterprise’s earning power.
- To supply information relating to resource utilization to judge the ability and effectiveness of the enterprise.
- To provide factual and interpretive information relating to the enterprise’s earning power and disclose assumptions made in this regard.
- To provide a statement of financial position useful for predicting, comparing and evaluating an enterprise’s earning power. (The events that are a part of the incomplete earning cycle and the current and the historical costs of the assets and liabilities along with relative uncertainties should be disclosed.)
- To provide information on factual aspects of an enterprise’s transactions having or expected to have significant cash consequences.
- To provide information on the net result of the completed earnings cycles and the progress made towards completion of incomplete earnings cycles.
- To provide information necessary for financial forecasts.
- To provide information that is useful for evaluating the effectiveness of management of resources in achieving the organization’s goals.
- To provide information relating to the activities of the enterprise affecting society which can be determined and described or measured and which are important to the role of the enterprise in its social environment.
The study group report contains the objectives of financial reporting in such a way that the enterprise providing such information through financial statements along with annexure cannot escape from the responsibility of accountability.
The objectives mentioned in the earlier section indicate that financial information reporting is needed for decision making (internal or external use). That means the quality of the information should be such that it should command wider acceptance and recognition for making information useful. In this sense, the reported financial information should have:
FASB Concept No.2 (Qualitative characteristics of the accounting information, May 1980), recognizes ‘relevance and reliability’ as primary qualitative characteristics, and other remaining characteristics as ingredients of these primary qualities. The AAA includes that:
To be useful in making decisions, financial information reporting must possess several normative qualities. The primary one is the relevance to the particular decision at hand of the attribute selected for measurement. The secondary one is the reliability of the measurement of the (relevant) attribute. Objectivity, verifiability, freedom from bias and accuracy are terms for overlapping parts of the reliability quality. Other qualities such as comparability, understandability, timeliness, and economy are also emphasized. A set of such desirable qualities is used as criteria for evaluating alternative accounting methods.
If the reporting financial information possesses the qualities cited in the above definition, then the information user may attribute different meanings to each of the characters and interpret the information to make proper decisions.
If the business enterprise is honest, sincere and transparent in reporting financial information, then the quality of information is bound to satisfy the norms prescribed and one can rely on such information for one’s own benefit. Further, if the financial reporting is adequate and reliable, it can be used for economic decisions such as relating to cost of capital, fluctuations in price of shares and stocks; employee decisions concerning job security, promotional opportunities and bonus declaration; customer decisions such as continuing supplies of goods, expected valuation in prices of goods, financial institutions to assess the present and future solvency, etc.; managerial decisions relating to operating, financing and investment decisions; and decisions relating to the environment and social responsibility.
Although users may have conflicting views based on their needs, an enterprise is expected to report the financial information which serves the general purpose of every user. If additional information is needed for a specific purpose, the same can be furnished in the form of schedules, notes, and information specific on-demand. However, ‘it is necessary that the reporting information relating to the financial statements and annexure be relevant and reliable.
Financial Reporting Needed for:
- Economic decisions
- Decisions relating to the cost of capital
- Decisions relating to fluctuations in the price of shares and stocks
- Employee decisions
- Customer decisions
- Managerial decisions
- Decisions relating to the environment and social responsibility
Importance of Financial Reporting
- Crucial information is communicated through financial statements.
- The basic objective of reporting information is to facilitate decision-making.
- Reporting information should cover both monetary and non-monetary information.
- Basic objectives of financial reporting are two: (1) to help the users make investment decisions, and (2) to provide information to judge the effectiveness of the enterprise.
- Objectives of financial reporting have been developed by experts and professional bodies to ensure accountability.
- The primary qualities of financial information reporting are relevance and reliability.
- Reporting information should be adequate and reliable to both internal and external users to make decisions.