Financial Statements and their Impact on the Capital Market - Literature review Example

Financial ments and their impact on the capital market Table of Contents Table of Contents 2 Introduction 3 Theories of Corporate Reporting Practises 4 Literature Review 8 Contemporary Issues 11 References 15 Introduction In an organisation a manager aims at increasing its earnings. The position and the compensation of a manager are closely related to the earnings of the organisation. Thus their primary focus is on the earnings growth of the company. On the other hand the investors make their investing decisions based on the information provided by the auditors. The financial statement of an organisation provides financial information based on which the stock prices change. This information helps the investors to make investment decisions. The GAAP represents a true and fair view of the information about a particular company. But it has been seen many times that the managers manipulate the exact figures provided in the financial statement of a company in such a way that it has no resemblance with the actual performance of the company (Naser, 1993; McNichols and Wilson, 1998; Shah, 1998). This is also termed as creative accounting. The manipulation of the exact figures in the financial statement affects the stock prices in the market and as a result the values are deviated from the correct values. This creates a misleading image of the company in the market and hence misguides the decisions of the investors. Previous research works by eminent scholars have shown positive abnormal returns due to the change in the earnings of an organization (Latane and Jones, 1979; Foster et al., 1984; Bernard and Thomas, 1989). The returns alter depending upon the validity of the changes in the earning. If the accounting is done in a fair manner then the above statement is true and is profitable for an organization. However if manipulations have been done on the actual earnings figure then the statement turns out to be false. There have been methodologies implemented by researchers in order to detect the true and fair view of the financial statements. One group of researchers have made an analysis of the management of the fraud in the best possible manner. For example- logit regression analysis has been made by the research scholars Hansen et al. (1996) and Beasley (1996). Many researchers like Bologna et al. (1996), Hollman and Patton (1997) and Zimbelman (1997) have made analysis based on the ratios derived from the financial data. The second group pays attention on the analysis of the accruals. Accruals are mainly the difference between the earnings of an organization and its cash flows. When the accruals are very high then it means that the figure of the earning in an organization is very high as compared to its cash flow. This is because of the manager’s decision of the disclosure time and amount of the revenues and costs. Many researchers have revealed that the organizations with high accruals perform respond badly in the stock returns whereas the organizations with low accruals provide good value as stock return (Sloan, 1996; Hribar, 2000; Houge and Loughran, 2000). Thus it is very important for each and every organization to portray the exact facts and figures in the process of accounting which would otherwise cause the decline of stock prices. Theories of Corporate Reporting Practises The true and fair view of the financial statements is very important for the decision making of the investors. This portion of the project will state the importance of the true and fair view of the financial statements in the UK GAAP and IFRS. It has been mentioned in section 393 of the Companies Act 2006 that a company’s directors should not approve its accounts until and unless they disclose the true and fair view of the financial statements. The requirement of true and fair view has been important to accounting in the United Kingdom from many years. It is important for EU as well as the UK law. The addition of IFRS in the UK did not bring any change to the fact that the true and fair view is very important for accounting. There was an Opinion received in the year 2008 from Martin Moore QC where it was clearly mentioned that the true and fair view is a necessary factor in the presentation of the financial statements of the UK companies. This Opinion was obtained by FRC. The rules for acquiring true and fair view of the financial statements may differ slightly. This Opinion stated that a fair presentation made under the IFRS is similar to the true and fair view. While preparing the accounts of a particular company, its true and fair view should always be kept into consideration. While preparing the accounts, the professional judgement becomes very important. It is very important to ensure that the accounting policies that are selected for a particular company fall under the UK GAAP and are best suitable for it. It is very important to establish the accounting policies for those items which are not covered by the accounting standards. In such cases the approach that has been made in IAS 8 to consider the accounting standards for similar type of items may be suitable. But applying a particular accounting standard for a different kind of item will not provide a true and fair view. A company should always provide information with detailed accounting rules. If the accounting rules are not provided in details then it represents poor accounting. Appropriate disclosures of the information related to all the items in the financial statement should be made even where they are not required by the accounting standards. It is to be ensured that the significant information is not provided by irrelevant disclosures. At the end, the full accounting process is to be checked so that it shows the true and fair view. Both UK GAAP and IFRS are now focussing on the presentation based on neutral financial information. For example- The disclosure of the hidden reserves and excess provisions at a later time is not allowed. The concern related to the smoothing of the earnings is increasing gradually. It is due to this reason that the neutrality of the accounting information is very important. While valuing the stocks or the inventories, the values are written down when the net realisable value is lower but never increased when it is higher. Judgement related to the fair value of the financial assets is very important. True and fair view of accounting is not an addition to the accounting standards. The entire aspect of the accounting standards is to provide recognition, the correct measurement, the neutral presentation and the disclosure of the important constituents of the financial reporting in such a way that it portrays the financial reality which will itself give the true and fair view. It requires extensive consultation in order to implement the accounting standards. As a result in maximum cases it will represent the true and fair view. The area where the accounting standards cannot address an issue properly, then the proper disclosure is the best solution for that issue. When the directors and the auditors think that implementing a particular accounting policy will not result in giving a true and fair view, they need to adapt a different policy requiring a departure from the standards. These circumstances mainly arise where they are not covered by a relevant accounting standard. When a company takes the decision of departing from a standard in order to provide a true and fair view, a proper explanation is required for such shift. The Financial Review Panel will be cautious to substitute its decision unless they are satisfied with the reason for which the board has taken such decision. It is also the responsibility of the auditors to judge the true and fair view of the financial statements. They should handle their legal as well as professional responsibilities properly. They should check in the entire process of the audit that the accounts do really show a true and fair view. The auditors should ensure that the consideration they are providing to the financial matters is also evident in their documentation. This will help to ensure that the accounts in the country maintain the high quality which the users and the investors expect. Thus both the directors and the auditors should perform their functions properly in order to provide a true and fair view of the financial statements. The use of high earning management should be avoided as it might lead to decrease in the stock returns resulting in a poor condition in the stock market. In order to avoid any kind of manipulations made in the financial statements by the managers, the directors need to function properly. They should not approve the accounts unless they maintain the transparency. The manipulations made in the financial statements may provide some advantages to the managers initially, but decreases the earnings of the company in future. This results in low quality rating of the company. The stock returns are inversely related to the earnings management. Higher earnings management results in declining position in the stock market. The reliability in the figures provided in the financial statements is very important. Importance should be given to the fair valuation of the assets and liabilities in the financial statements. A proper financial analysis will help to find the economic condition of a company. The objective of the financial analysis is to assess the performance of a company and its financial condition. The analysis should include the risk that may arise due to the earnings management. The financial statement should always reveal the actual economic scenario of the company. This will help the investors to determine how efficiently the company has applied the accounting policies in reducing its risks. Fair value reporting helps in examining the reality of the economic scenario revealed in the financial statements. Continuous manipulation being performed by the managers may lead to the situation of financial distress for the company. These practises should be stopped and implementation of the accounting standards covered under the GAAP should be made in order to avoid risk involvement. A fair value reporting approach enables the investors to predict the reliability on the performance of the company and also on its future cash flows. The realistic data available in the balance sheet gives the company a platform to reveal the actual performance and develop future cash flows. The detailed rules and regulations to prepare the financial statements should be used in order to avoid the practise of earnings management by different companies. Literature Review Among the researchers, Siegel and Shim (1981) were the first to examine on the relevant issues of the financial statements as a factor of the relationship between the earnings and its return. This research stated that the companies having same earnings are rated by the investors based on their quality. The calculation of price earnings ratio serves the purpose. A company with higher price earnings ratio will have higher quality. The quality of the earnings of a company is not always dependant on the decisions taken by the managers but may also vary because of the business conditions. Using the accruals for the purpose of earnings management is a simple process to evaluate the earning quality of a company. Many researchers have made researches to diminish the accruals between non discretionary components reflecting the effect on the business conditions and the discretionary components reflecting the manager’s decisions. Jones (1991) was the first researcher to estimate the non discretionary accruals as a function of the change or difference in the sales and in the level of the equipment, plant and other property. He argued that the accruals represent a discrete factor of earnings-return relation. The same research design was implemented by Subramanyam (1996), who stated that the US stock market performs price discretionary accruals. He argued here that the discretionary accruals possess the ability to ascertain the future profitability and also the dividend changes. Thus accruals being considered as an important variable can be used to assess the relation between the earnings and its returns. These findings have been verified by the researches made in the emerging market also. Vafeas et al. (1998) have stated that the stock market of Cyprus also gives importance to the cash flows and the accruals for evaluating the stock returns. The discretionary accruals were also used as an important variable to manage the earnings in the Belgian capital market, as stated by Bauwhede et al. (2003). It was found that companies in both public and private sector of Belgian were engaged in income smoothing in order to manage the earnings and reach the targets of the previous year earnings. Researchers found that the managers manage the earnings through discretionary accruals as a result of the difference between the earnings prior to management and the income objectives. Chan et al. (2001) studied the US data for a period of over 25 years and concluded that the accruals have a negative impact on the future stock prices. As a result of the high accruals the earnings increase which results in poor stock returns. This research is connected to the assumption that high accruals indicate higher manipulation in the earnings figure by the managers. Shaw (2003) has also made a research related to the income smoothing and the earnings management carried out in the US market. Higher quality firms make higher use of the discretionary accruals as compared to the lower quality firms. This means that higher quality firms make greater manipulation in the earnings as compared to the low quality firms. It can be concluded that researchers should be aware of the fact that higher accruals mean increased earnings management. On the other hand Francis et al. (2005) have stated that poor accrual quality results in high debt cost as well as high cost of equity. Both the discretionary as well as the non discretionary accruals are important tools while explaining the earnings management, but the effect of non discretionary accruals is higher on the earnings management. Most of the researches made have revealed the relevance of the data shown by properly examining the business conditions and also the benefits that the managers enjoy by manipulating the figures of the financial statements. Dechow and Skinner (2000), Shivakumar (2000), Eckbo et al. (2000), Brous et al. (2001), and Patten and Trompeter (2003) have stated that the manipulations in the financial statements are made by the managers for different purposes. The manipulations are done mainly for the purpose of issuing equity, avoiding tax, different bonus compensations and also for avoiding the political costs. Baralexis (2004) has argued that in the market of Greece the earnings have been manipulated by the Greek listed companies in order to receive huge funds from the external sources, to avoid receiving the reports of decreased earnings claiming the poor performance of the companies and also to avoid the taxes. Recent researches state that the Greek companies having high debt to assets ratio and high inventories to sales ratio and low net profit to assets, net profit to sales, working capital to assets and sales to asset ratios and thus suffering from financial distress are most likely to manipulate the data in the financial system to interpret a misleading financial statement for the companies. This is done in order to avoid the reporting of the poor performances by these companies. An analysis should be made on the key ratios by the analysts and the investors in order to have the exact information of the financial condition of these companies. These companies manipulate the financial statements in order to get huge fund from the external sources as well. Thus it can be said that the accruals and the key ratios are very important while determining the relation between the earnings and the returns. All the studies in the past have already shown that the accruals and the specific ratios play an important role in the determination of the quality of the financial information that is disclosed. When the earnings quality of a company is poor, then it means that there is some information asymmetry related to the announcement of the earnings. The earnings quality can also affect the cost of capital of a company by means of its affect on the trading costs. A company having high accounting quality is always rewarded with low cost of debt. It has been seen that high managed earnings always result in the low quality rating of the company. However it does not mean that a lack in the management of the earnings will result to high quality of the company. There are other factors also that determine the quality of a company. High quality of earnings means that the earnings are conserved whereas low quality earnings mean that the earnings management is very high. This implies that there has been greater manipulation in the financial statement that has been published. The basic goal of the accrual accounting is to help the investors by providing them with the financial performance of the companies for a particular period of time by using various accounting principles. Many researchers have revealed that the accrual accounting results in earnings which are smoother as compared to the cash flows. The accruals are inversely related to the cash flows and the earnings derived from accrual accounting provide much better information related to the financial performance of a company as compared to the cash flows. Many researches have been done on the impact of the accrual accounting for the interpretation of the future earnings. It was concluded that the companies with higher accrual quality have higher chance of getting declining earnings in future. Higher accruals result in poor stock returns thereby affecting the stock market negatively. Thus higher manipulation in the financial statements of different companies increases their earnings initially resulting in poor condition in the stock market. It can benefit the managers to avoid taxes and disclosure of the poor performance of the companies, but it decreases the quality of the company and its earnings for investing purpose and also affects the sock prices adversely. It can be concluded from all the aforementioned researches that the accruals play a vital role in determining the quality of the financial information that are disclosed. Contemporary Issues Several companies have manipulated the actual figures in the financial statements which resulted in their bankruptcy. This part of the project will describe some of the companies which practised the technique of manipulation in the financial statement and the effect of the bankruptcy of these companies on the financial markets and the investors. Enron was formed in the year 1985. Internorth Inc. and Houston Natural Gas Corporation merged together to form Enron. It got the opportunity to distinguish itself as a prominent leader in the natural gas market. It was very surprising that a big company like Enron disappeared in one night. The CFO of the company Andrew Fastow made the plan to give a big shape to the company by manipulating its financial statements despite of the fact that its subsidiaries were suffering from losses. This purpose was achieved by the scheme of special purpose entities (SPE) which allowed hiding of assets that were losing their value and hiding of the business ventures that had gone down. The transactions that were shown in the financial statements were far away from the exact figures and were made in order to increase the share price of the company. The disclosure of this fact resulted in the bankruptcy of the company. The investors lost their faith on the audited statements of the companies. The other accounting firms were also suffering as the customers lost their trust on their financial reports. The investors were moving away from the capital market. This reduced the stock prices in the USA market. Another company which has violated the GAAP rules is Nortel Networks Corporation. It was a telecommunication company headquartered in Ontario, Canada. The company was performing at its peak till the year 2000. The accounting fraud was performed by the company in order to bridge the gap between the true performance and the investors and customers expectation. The projected sales of the company had no similarity with the actual sales volume. The managers conducted this fraudulent activity in order to increase their incentives. They deceived the Nortel investors and this level of misconduct resulted in losses in billion dollars to the shareholders. The company violated all the accounting principles and the disclosure of a clear picture of the performance of the company to its investors was unavailable. At one point of time Nortel used to hold one third of the stock value of S & P Composite Index. The downfall or rise of Nortel was considered to be the judgement for the entire Canada. The downfall of the company decreased its stock price by 335 percent. A large number of Canadians were holding the Nortel shares. This event resulted in huge loss for these shareholders. The company being one of the biggest companies in Canada, its bankruptcy had an adverse effect on the stock market. WorldCom is another example. It was a telecommunication company headquartered in Virginia, USA. It was one of the leading telecommunication companies. In the year 1998 the stock prices of the company began to decline which resulted in the slowdown in the telecommunication industry. After the downfall of the stock prices and the failure of the buy back of the shares it was found that the company was using fraudulent accounting methods in order to increase its share price. Thus the company had to file for bankruptcy. The investors had to incur huge losses due to this bankruptcy. Parmalat was another such company conducting fraudulent financial statements. It is a multinational Italian food corporation headquartered in Collecchio, Italy. The presentation of falsified accounting statements resulted in the bankruptcy of the company. The bondholders had to suffer for this corporate financial fraud. This event also had a negative impact on the Milan stock exchange. Lehman Brothers Holdings Inc. was one of the leading investment banks in United States. Its failure is another example of the unfair practices carried out in accounting by violating the principles. Its financial strategy was to invest to a huge extent on the mortgage debts in those markets which were not under the consumer protection of the government of the United States. The losses and the debts were mounted and the Government disagreed to extend the loan to the bank. Lack of the proper framework was a problem that the company was facing. The abnormal incentives of the managers increased their greed which resulted in the violation of the accounting principles and failure of the company to show the transactions in Repo 105 to its investors. This downfall affected the entire global market. The stock prices went down in Europe, Asia and the United States. In Europe, the FTSE index had a downfall of 3.92 percent whereas the NASDAQ composite had a decline of 3.6 percent which had an unfavourable effect on the stock market. Among the Asian countries India’s Sensex went down by 5.4 percent. This bankruptcy has hit the stock markets globally. It is evident from the aforementioned incidents that the performance of the manipulation in the financial statements has a negative impact on the investors, the stock market as well as on the company practising such methods. The disclosure of such fraudulent activities results in the bankruptcy of these companies. In order to protect themselves from the accounting scandals, these companies should follow the accounting principles. The violation of the GAAP rules should be avoided by the companies. The companies should maintain true and fair view of the financial statements and disclose all the accounting transactions in details, so that the investors can seek the exact information about the financial performance of the company. This will help to achieve the investor’s reliability and increase their earnings. The proper functioning of the auditors and the directors will protect the investor’s interest. It is also the responsibility of the investors to understand the disclosure quality of the companies based on which they can make their investment decisions. References Baralexis, S., 2004. The a priori relevance of earnings management to Greek financial Reporting. Paper presented at 3d Annual Conference of the Hellenic Finance and Accounting Association. Bauwhede, V., Willekens, M. and Gaeremynck, A., 2003. Audit firm size, public ownership and firms’ discretionary accruals management. The International Journal of Accounting, 38(1), pp. 1-22. Beasley, M.S., 1996. 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