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)