Financial Reporting Environment Overview

The Financial Reporting Environment

• Accounting is the process of identifying, measuring, and communicating financial information about economic entities to interested persons.
• There are two primary types of accounting:
  • Financial accounting: Prepares financial statements for internal and external users like investors, creditors, and others.
  • Managerial accounting: Communicates financial information through various reports for internal decision-makers like management.
• The major financial statements are used to communicate financial information to outsiders and include:
  • The statement of financial position (balance sheet)
  • The statement of income/comprehensive income or income statement or statement of profit or loss or statement of financial performance
  • The statement of cash flows or cash flow statement
  • The statement of changes in equity (IFRS).

Key Stakeholders in Financial Reporting

• Key stakeholders directly rely on financial information for resource allocation, including investors and creditors.
• Other stakeholders help in the efficient allocation of resources, including financial analysts and regulators.
• Those who prepare, rely on, review, audit, or monitor financial information are all considered key stakeholders.

Stakeholder Responsibilities

• Management is responsible for preparing the financial statements.
• Independent auditors audit the statements on behalf of shareholders to ensure management accountability.
• Standard setters create the generally accepted accounting principles (GAAP) for accounting guidance.
• Securities commissions and stock exchanges monitor for full and plain disclosure in submissions.
• Credit rating agencies and analysts monitor and analyze signs of financial condition changes.

What is at Stake?

• Investors/creditors are at risk of losing their investment or loan principal.
• Management's reputation, compensation, and access to capital markets are at stake.
• Securities commissions and stock exchanges are at risk of a poor reputation and an inefficient market.
• Analysts and credit rating agencies' reputations are also at stake.
• Auditors are at risk if their clients fail, and standard setters are at risk of losing credibility.
• Other stakeholders have various levels of risk dependent on their involvement with the entity.

Objective of Financial Reporting

• The objective of financial reporting is to provide financial information about the reporting entity that is useful to current and potential decision-makers.
• The decision-usefulness approach aims to provide investors with information that helps them assess:
  • The company's ability to generate net cash inflows.
  • Management's ability to protect and enhance investments.
• This information must be tailored to different users with diverse needs and levels of knowledge.

Information Asymmetry

• Ideally, all stakeholders should have equal access to relevant information, but this is often not the case.
• When managers have more information than other stakeholders, information asymmetry exists.
• Companies must weigh the costs and benefits of sharing information, as they are caught between the need for transparency and protection of proprietary information.

Types of Information Asymmetry

• The efficient markets hypothesis suggests that markets reflect publicly available information, but human behavior can be motivated by self-interest.
• Two main types of information asymmetry problems:
  • Adverse selection: Capital markets may attract the wrong participants when information asymmetry exists.
  • Moral hazard: Individuals could shirk responsibility if there is no accountability for their actions.

Generally Accepted Accounting Principles (GAAP) Hierarchy

• The GAAP hierarchy ranks sources of accounting standards in descending order of authority.
• The purpose of the hierarchy is to:
  • Define what constitutes GAAP.
  • Rank sources based on their importance.
  • Ground standards in the conceptual framework.
  • Establish the value and expectation of professional judgement.

Professional Judgement

• Accounting standards are primarily based on principles rather than specific rules.
• Accountants are expected to apply GAAP appropriately to any situation using their professional judgment.
• If no principle exists, professional judgement is used to find a solution.
• U.S. GAAP is more prescriptive and provides more detailed guidance than IFRS and ASP.

Challenges and Opportunities for the Accounting Profession

• The COVID-19 pandemic accelerated the move of many businesses online.
• This shift led to a dramatic increase in automation and the use of technology.
• Accountants had to adapt their roles to this new environment which led to two key areas of focus: Data Governance and Economic Value Creation.

Impact of Technology: Data Analytics

• The digital world has led to an abundance of information, particularly "big data" that requires systems for capture, storage, and access.
• This has created a demand for data analytics and new jobs.
• Accountants must embrace new opportunities without losing the quality and content of their work.

Impact of Technology: Data Governance

• Data governance focuses on processes, roles, policies, standards, and metrics to ensure effective and efficient use of information.
• This is essential for an organization to achieve its goals.

Sustainability Reporting (ESG)

• Value creation is the process of creating potential for future revenue, net income, and benefits for stakeholders.
• ESG (environmental, social, and governance) issues are important for generating economic value.
• Sustainability reporting discloses information related to ESG issues.

Some Issues to be Addressed with ESG

• Environmental issues include climate change, air quality, energy management, biodiversity, land uses, and greenhouse gas emissions.
• Social issues include human capital management, diversity and inclusion, health and safety, product safety, cybersecurity, and data privacy.
• Governance issues include the quality of the board of directors, oversight of executive performance/compensation, and oversight of company strategy, risk management, performance, and disclosures.

Disclosure Guidelines and Frameworks

• Several global frameworks provide guidance for ESG reporting and disclosures:
  • Global Sustainability Standards Board (GSSB)
  • International Integrated Reporting Council (IIRC)
  • Sustainability Accounting Standards Board (SASB)
  • Financial Stability Board (FSB)
  • Climate Disclosure Standards Board (CDSB)
  • World Economic Forum (WEF)

Explore the fundamentals of the financial reporting environment in this quiz. Learn about the types of accounting, key financial statements, and the stakeholders who rely on financial information. Perfect for students or professionals looking to reinforce their understanding.