This article appeared in Finance Magazine

Financial Reporting - an endangered discipline?
The role of accounting numbers has come under close scrutiny in the last decade. Antoinette Flynn investigates the changing role of financial reporting.
Researchers have found conflicting evidence about the relevance of financial data to capital markets, especially the earnings per share (EPS) figure. Some conclude that EPS is an outmoded and distrusted number and is no longer an adequate means to relay information to capital market investors. Evidence from capital markets around the world shows that investors react differently to the release of positive and negative earnings. Negative earnings have a stronger connection with stock prices, albeit in an environment where accounting numbers are less influential overall. One interpretation of this result is that capital market participant’s view accounting information cynically, especially when it’s positive in nature. Investors are now looking beyond the ‘bottom line’ (the profit and loss statement) for clues about the current and potential wealth generating prospects of companies.

Staying within the realm of financial reporting, some are turning to other less obvious financial indicators. Researchers have noted that the book value of equity appears to be gaining in popularity among investors at the same time as the relevance of earnings has decreased. Others have found that the combined value relevance of earnings and book value has increased slightly over the last four decades. Not surprisingly, that increase has been attributed to the rise of the value relevance of book values (the balance sheet).

This switch of emphasis from earnings to book values (from the profit and loss statement to the balance sheet) has been linked to a changing economic environment. Forty years ago, global economic activity was generated in the main through the manufacturing sector. Today, economic activity is predominantly in services and intangible assets-based industries in the developed world. As a consequence, earnings are more transitory in nature and indeed many more firms are recording losses than ever before. The commercial rate of change is accelerating and paradoxically, it is commonplace to frequently see one-time items appearing in the profit and loss statement.

The capital market emphasis is not clearly divided between either earnings or book values. The focus depends on a number of firm characteristics. For example, the nature of the firm’s development, whether it is in growth or decline affects the importance of earnings and book values from the investor’s perspective. The valuation of a firm in decline is centred on the potential liquidation values (book values) rather than future earnings prospects.

Now that some of the focus has turned towards book values, the question of the inclusion and valuation complexity of intangibles in the balance sheet arises. This is not a new concern and has been raised in many guises in recent years, but has yet to be adequately resolved. For example, recent research in the software industry has shown that CFOs in this high value-added industry perceive that the source of corporate wealth stems from intangible assets, the intellectual and human capital of these organisations, neither of which appears explicitly on the balance sheet. Current financial accounting systems effectively ignore these assets and the result is a chasm between the official financial position and the actual wealth capacity of the company. Has the commercial world outgrown the constraints of the profit and loss statement and the balance sheet?

In a word, yes. Capital markets have been forced to find alternative indicators of firm worth as relevant inputs in stock market valuations. Admittedly, some of these are based on permutations and combinations of the profit and loss statement and the balance sheet, (i.e. economic value added, EVA and market value added, MVA), while others are less traditional based on non-financial indicators (i.e. the rate of new product development, the strength of supplier relations). Clearly the dominance of financial statements as a key source of information of capital market participants is waning. In short, financial accounting systems stand accused of being detached from the heart of the contemporary commercial world (a condition if prolonged, could result in the demise of financial reporting).

This same accusation was levelled at the management accounting discipline in the 1990s. Traditional management accounting techniques focused on measuring and controlling financial performance through hierarchical budgetary systems. Two major flaws have been identified with that system of organisational control. Firstly, the needs of customers were not central to that system and secondly, the negative behavioural effects on employees were not openly addressed.

Today, there are many alternative management accounting techniques to effectively control and measure core profitability. Their practical application has resulted in a change in organisational structure towards decentralisation, employee empowerment, group and/or relative targets and an absence of budgets. Companies like Marks and Spencer, IKEA, Ericsson, Boots and Diageo are all moving towards this new configuration and explicitly recognising that added value flows from employees to customers.

Unfortunately, the development of these pioneering management accounting systems has not included a means of transferring that knowledge to external stakeholders through financial statements. One could argue that this has resulted in weaker market confidence in and reliance on financial reporting to capture the essence of value generation within organisations. It appears that management accounting has outpaced the developments in financial accounting and has effectively placed it on the ‘endangered disciplines’ list.

Currently, activists and practitioners of current financial reporting systems energetically debate the finer points of financial reporting standards without much pause to consider whether their efforts will be relevant to future organisations and capital markets. For example, whether accounting standards should be harmonised or not is an ongoing hot topic. The assumption that harmonising different national accounting systems will create a catalyst for international capital market integration is not sustained by recent evidence. In an examination of the major seven countries of the OECD (Australia, Canada, UK, USA, Germany, France and Japan) Land and Lang (2002) have found that since 1985, these major capital markets are consistently behaving in a similar manner to each other, a pattern that cannot be explained by underlying economic factors (growth and interest rates). This suggests that international capital markets are beginning to operate in concert despite a lack of formal accounting harmonisation.

The myopic concentration on the process of reporting financial information makes it difficult to openly discuss a more fundamental question - the relevance of the information reported.

Currently, the international relevancy trends in financial reporting information indicate that this discipline could face a further decline. This is not an inevitable outcome. Inspiration and direction can be taken from the management accounting irrelevancy crisis. Creative solutions will benefit all stakeholders and more immediately, the accounting profession. Firm-specific integrated financial and non-financial information prepared by accountants will ensure their pivotal role in monitoring and reporting the wealth generating capabilities of firms.

Ref: Land J. and Lang M. (2002), ‘Empirical evidence on the evolution of international earnings’, The Accounting Review, Vol. 77, Supplement, pp. 115-133.
Antoinette Flynn is a lecturer in the Department of Accounting and Finance at the University of Limerick.
This article appeared in the May 2003 edition of Finance Magazine.